capitalist_and_entrepreneur_klein

e Capitalist and the Entrepreneur

e Capitalist and the Entrepreneur
Essays on Organizations and Markets
Peter G. Klein

Copyright © 2010 by the Ludwig von Mises Institute
Published under the Creative Commons Attribution License 3.0.
http://creativecommons.org/licenses/by/3.0/
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e entrepreneur hires the technicians, i.e., people who have the
ability and the skill to perform definite kinds and quantities of
work. e class of technicians includes the great inventors, the
champions in the field of applied science, the constructors and
designers as well as the performers of the most simple tasks. e
entrepreneur joins their ranks as far as he himself takes part in the
technical execution of his entrepreneurial plans. e technician
contributes his own toil and trouble; but it is the entrepreneur
qua entrepreneur who directs his labor toward definite goals. And
the entrepreneur himself acts as a mandatary, as it were, of the
consumers.
—Ludwig von Mises, Human Action (1949), p. 300

Contents
Foreword by Doug French
Introduction
iii
vii
1 Economic Calculation and the Limits of Organization 1
e Textbook eory of the Firm . . . . . . . . . . . . . . . 3
Coase and Transaction Costs . . . . . . . . . . . . . . . . . . 4
Economic Calculation and the Limits to Firm Size . . . . . . . 5
Alternative Austrian Approaches . . . . . . . . . . . . . . . . 18
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2 Entrepreneurship and Corporate Governance 23
Limits of the Standard Approach to the Firm . . . . . . . . . 24
Two Alternative Perspectives . . . . . . . . . . . . . . . . . . 25
e Contractual Approach . . . . . . . . . . . . . . . . . . . 27
Building Blocks of an Austrian eory of the Firm . . . . . . . 28
Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . 35
Toward an Austrian eory of Corporate Governance . . . . . 37
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3 Do Entrepreneurs Make Predictable Mistakes? 49
Entrepreneurship, Profit, and Loss . . . . . . . . . . . . . . . 54
Mergers, Sell-offs, and Efficiency: eory and Evidence . . . . 57
i

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Are Divestitures Predictable? Evidence from a Duration Study . 60
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4 e Entrepreneurial Organization of Heterogeneous Capital 67
Entrepreneurship, Judgment, and Asset Ownership . . . . . . 69
Capital eory and the eory of the Firm . . . . . . . . . . 71
e Attributes Approach to Capital Heterogeneity . . . . . . . 75
Organizing Heterogeneous Capital . . . . . . . . . . . . . . . 80
Concluding Discussion . . . . . . . . . . . . . . . . . . . . 87
5 Opportunity Discovery and Entrepreneurial Action 93
Entrepreneurship: Occupational, Structural, and Functional
Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . 95
Entrepreneurship as Opportunity Identification . . . . . . . . 99
Entrepreneurial Action, Heterogeneous Capital, and Economic
Organization . . . . . . . . . . . . . . . . . . . . . . . . 109
Applications of Entrepreneurial Action . . . . . . . . . . . . . 113
Summary and Conclusions . . . . . . . . . . . . . . . . . . . 116
6 Risk, Uncertainty, and Economic Organization 117
Knight, Mises, and Mises on Probability . . . . . . . . . . . . 118
Uncertainty and the Entrepreneur . . . . . . . . . . . . . . . 121
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
7 Price eory and Austrian Economics 125
Central emes of Austrian Economics Before 1974 . . . . . . 129
Equilibrium in Austrian Price eory . . . . . . . . . . . . . 135
Knowledge, Expectations, and the Convergence to Equilibrium 139
A New Way Forward for Austrian Economics: Developing Austrian
Price eory . . . . . . . . . . . . . . . . . . . . . 150
8 Commentary 153
A Government Did Invent the Internet, But the Market Made
it Glorious . . . . . . . . . . . . . . . . . . . . . . . . . 153
B Networks, Social Production, and Private Property . . . . . 157
C Why Intellectuals Still Support Socialism . . . . . . . . . . 162
D Management eory and the Business Cycle . . . . . . . . 169
E Menger the Revolutionary . . . . . . . . . . . . . . . . . 171
F Hayek the Innovator . . . . . . . . . . . . . . . . . . . . 175
G Williamson and the Austrians . . . . . . . . . . . . . . . 187

Foreword
by Doug French
Entrepreneurship has been a hot buzzword recently. Classes in entrepreneurship
are being taught at both the high school and college levels.
e Ewing Marion Kauffman Foundation: e Foundation of Entrepreneurship
has big fancy websites advertising that its President and CEO
will give a “State of Entrepreneurship Address.” ere are global entrepreneurship
conferences being held in far-flung places like Dubai. Learning
programs are offered to test your “Entrepreneurial IQ.” e United States
government even has an entrepreneurship website, advertising a Presidential
Summit on Entrepreneurship, Entrepreneurship Law, and a Global
Entrepreneurship Week.
Is it that simple? If more classes, websites and conferences are offered
will we really have more Ewing Kauffmans? A man who as a child was
bedridden for a year with a heart ailment but used the time to read 40
books per month. After WWII he worked as a pharmaceutical salesman
until, with a $5,000 investment, he started Marion Laboratories. Company
sales were just $39,000 in the first year of operation but four decades
later Kauffman’s company would have revenues totaling $930 million.
In 1989, Kauffman merged Marion with Merrell Dow Pharmaceuticals,
making more than 300 millionaires of Marion investors and employees.
Kauffman himself would likely have not stepped into the role of entrepreneur
if not for the stupidity of his employer, Lincoln Laboratories.
A natural salesman and hard worker, Kauffman in just his second year
earned more in commissions than the company president did in salary. In
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response, the president cut Kauffman’s commissions. Despite the reduction,
Kauffman still out-earned the Lincoln head man the following year,
so “he took away some of my territory, which was the same as taking away
some of my income,” Kauffman related later. “So, I quit and I started
Marion Laboratories in the basement of my home.”
e government can talk about entrepreneurship and act like it is
promoting it, but all of what government does by taxing and regulating
impedes the entrepreneur. It’s hard to imagine that even Ewing Kauffman
could make a similar initial investment today (roughly $44,000 adjusted
for inflation), start a firm in his basement, and build it to a billion dollar
company. e local authorities in Kansas City were not all that concerned
about a fledgling pharmaceutical company operating from Kauffman’s
home in 1950. Today, there would be permits to obtain, approvals
to be gained and license fees to pay. e majority of the legislation that
has given the Food and Drug Administration (FDA) its enormous power
was enacted after Kauffman’s company was up and running.
But as long as there is some shred of a market available, entrepreneurs
find a way. ey see opportunity others don’t. ey take financial risks
that most people would consider unfathomable. e government edicts,
bureaucratic roadblocks and oppressive taxation that discourage the hardiest
of souls only serve to challenge and inspire creative entrepreneurs while
weeding out potential competitors. All of the wonderful goods and services
that we enjoy are due to entrepreneurship and the firms that are created to
carry out the dreams of the entrepreneur and serve customers.
It is the firm where most people work. Maybe its a small firm or a
big one or one in-between, but unless one is a solo contractor most people
trade their time and talent for a paycheck to pay the bills. e vast majority
of working people don’t give much thought to this framework. ey clock
in, they clock out. Payday every couple of weeks. At the same time most
people will spend the majority of their non-sleeping hours on the job,
working for a firm or series of different firms. And work life maybe the
single most important part of a person’s life. Reportedly 95% of the people
who are happy on the job are happy with their life as a whole. But salaried
workers, from the lowest paid to the highest, take no risk. And although
they are critical to the production of products and services, they are a cost
of doing business.

v
Conversely, the entrepreneur is only paid when the market accepts his
or her product. If the market rejects the product, the entrepreneur is not
only not rewarded, but most times will lose capital that had been saved
previously and was invested in the idea and production. As Kauffman
explained, “e odds were strongly against me when I started. ere were
two or three thousand pharmaceutical businesses started after World War
II, and only three ever really succeeded.”
As vital as entrepreneurship and the firm are to the working of the
market and lives of virtually all working men and women, most schools
of economic thought are silent on the subject. Even the work that has
been done is incomplete and contradictory. Economists can’t even agree
on what entrepreneurship is or what exactly entrepreneurs like the late
Ewing Kauffman do. And the apparatus that facilitates the manifestation
of the entrepreneurial vision—the firm—is but a “black box” where inputs
enter and outputs emerge, like so much magic.
But like so many market phenomena that modern economics chooses
to ignore or get wrong, an Austrian economist has entered the black box,
examining its contents for a better understanding of not only what entrepreneurs
are, but what they do and why they do it. Peter G. Klein has
devoted his entire career to understanding the entrepreneur and the firm,
bringing a distinctive Austrian approach to the problem while drawing
from what all schools of thought have to contribute.
is book contains the fruit of Dr. Klein’s labors. And while the majority
of the book was taken from articles appearing in academic journals, this
book should not only be read by students and academics. Klein provides
valuable insight that business owners and managers will find useful. As
heroic as the entrepreneur may appear or thoughtful as the manager may
seem, they don’t operate in a vacuum. Often they have no one to talk to
and nothing to keep them in check but their own egos, which in many
cases offers no check at all but the opposite.
e yearning for knowledge in this area is considerable. Considerable
space at most any bookstore is provided for the many and varied management
books. ere are nearly as many different management books offered
as diet books, with each genre being as faddish as the next. Management
theorists crank out a continual stream of books full of business advice that
“readers find unreadable,” writes e Economist’s Adrian Wooldridge, “and
managers find unmanageable.”

vi
While many great entrepreneurs cash in by writing books about their
management secrets and entrepreneurial exploits, their supposedly keen
insights are often weathered by time and selective memory. But most importantly,
these books imply that capital is homogeneous, that the wouldbe
entrepreneur can do what Jack Welch did, or emulate T. Boone Pickens,
or apply Ewing Kauffman’s strategies and expect the same result. ese
kind of books are good for inspiration but nothing more.
As Klein makes abundantly clear, capital is instead heterogeneous.
Entrepreneurship can’t be formulated in equations and sprinkled like pixie
dust on the masses by government initiatives or well-meaning foundations
with the hopes that the inner-entrepreneur in every citizen will be
summoned. Although the brilliant Mr. Kauffman supported the use of
his accumulated wealth to support programs promoting entrepreneurship,
such programs are often a malinvestment of capital. And the use of taxpayer
dollars towards such an endeavor is doubly wasteful.
It is however vital that we understand the function of the entrepreneur
and the process that is so critical to the advancement of society and wellbeing
of its members. As Klein pries open the entrepreneurial black box,
the glories and special talents of the entrepreneur are exposed, along with
the limitations of the firm. e market environment that allows entrepreneurs
to thrive is revealed. It is not that the society requires multitudes
of entrepreneurs, but only that those with this rare talent be allowed to
flourish unfettered. And for those readers who work for an agreed-upon
wage helping some entrepreneur become wealthy, an appreciation is gained
with the realization that ultimately it is only by satisfying customers that
their entrepreneur bosses become successful.

Introduction
As far back as I can remember, I always wanted to be an Austrian economist.
Well, not quite, but I was exposed to Austrian economics early on. I
grew up in a fairly normal middle-class household, with parents who were
New Deal Democrats. In high school, a friend urged me to read Ayn
Rand, and I was captivated by her novels. I went on to read some of
her nonfiction works, in which she recommended books by Ludwig von
Mises and Henry Hazlitt. I don’t remember which economics books
I read first, maybe Hazlitt’s Economics in One Lesson or Mises’s Anti-
Capitalistic Mentality. I didn’t understand the more technical parts of their
analyses, but I was impressed with their clear writing, logical exposition,
and embrace of liberty and personal responsibility. I took a few economics
courses in college and, while they lacked any Austrian content, I enjoyed
them and decided to major in the subject. I had a very good professor,
William Darity, who himself preferred Marx and Keynes to Mises but who
appreciated my intellectual curiosity and encouraged my growing interest
in the Austrians.
As a college senior, I was thinking about graduate school—possibly in
economics. By pure chance, my father saw a poster on a bulletin board
advertising graduate-school fellowships from the Ludwig von Mises Institute.
(Younger readers: this was an actual, physical bulletin board, with a
piece of paper attached; this was in the dark days before the Internet.) I
was flabbergasted; someone had named an institute after Mises? I applied
for a fellowship, received a nice letter from the president, Lew Rockwell,
and eventually had a telephone interview with the fellowship committee,
which consisted of Murray Rothbard. You can imagine how nervous I was
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the day of that phone call! But Rothbard was friendly and engaging, his
legendary charisma coming across even over the phone, and he quickly put
me at ease. (I also applied for admission to New York University’s graduate
program in economics, which got me a phone call from Israel Kirzner. Talk
about the proverbial kid in the candy store!) I won the Mises fellowship,
and eventually enrolled in the economics PhD program at the University
of California, Berkeley, which I started in 1988.
Before my first summer of graduate school, I was privileged to attend
the “Mises University,” then called the “Advanced Instructional Program
in Austrian Economics,” a week-long program of lectures and discussions
held that year at Stanford University and led by Rothbard, Hans-Hermann
Hoppe, Roger Garrison, and David Gordon. Meeting Rothbard and his
colleagues was a transformational experience. ey were brilliant, energetic,
enthusiastic, and optimistic. Graduate school was no cake walk—the
required core courses in (mathematical) economic theory and statistics
drove many students to the brink of despair, and some of them doubtless
have nervous twitches to this day—but the knowledge that I was part
of a larger movement, a scholarly community devoted to the Austrian
approach, kept me going through the darker hours.
In my second year of graduate school, I took a course from the 2009
Nobel Laureate Oliver Williamson, “Economics of Institutions.” Williamson’s
course was a revelation, the first course at Berkeley I really enjoyed.
e syllabus was dazzling, with readings from Ronald Coase, Herbert Simon,
F. A. Hayek, Douglass North, Kenneth Arrow, Alfred Chandler,
Armen Alchian, Harold Demsetz, Benjamin Klein, and other brilliant
and thoughtful economists, along with sociologists, political scientists,
historians, and others. I decided then that institutions and organizations
would be my area, and I’ve never looked back.
e essays collected in this volume reflect my efforts to understand
the economics of organization, to combine the insights of Williamson’s
“transaction cost” approach to the firm with Austrian ideas about property,
entrepreneurship, money, economic calculation, the time-structure
of production, and government intervention. Austrian economics, I am
convinced, has important implications for the theory of the firm, including
firm boundaries, diversification, corporate governance, and entrepreneurship,
the areas in which I have done most of my academic work. Austrian
economists have not, however, devoted substantial attention to the

ix
theory of the firm, preferring to focus on business-cycle theory, welfare
economics, political economy, comparative economic systems, and other
areas. Until recently, the theory of the firm was an almost completely
neglected area in Austrian economics, but over the last decade, a small Austrian
literature on the firm has emerged. While these works cover a wide
variety of theoretical and applied topics, their authors share the view that
Austrian insights have something to offer students of firm organization.
e essays in this volume, originally published between 1996 and
2009, deal with firms, contracts, entrepreneurs—in short, with the economics
and management of organizations and markets. Chapter 1, “Economic
Calculation and the Limits of Organization,” first presented in
Williamson’s Institutional Economics Workshop in 1994, shows how
the economic calculation problem identified by Mises (1920) helps understand
the limits to firm size, an argument first offered by Rothbard
(1962). It also offers a summary of the socialist calculation debate that has
worked well, for me, in the classroom. Along with chapter 2, “Entrepreneurship
and Corporate Governance,” it offers an outline of an Austrian
theory of the firm, based on the Misesian concept of entrepreneurship
and the role of monetary calculation as the entrepreneur’s essential tool.
“Entrepreneurship and Corporate Governance” also suggests four areas
for Austrian research in corporate governance: firms as investments, internal
capital markets, comparative corporate governance, and financiers as
entrepreneurs. Chapter 3, “Do Entrepreneurs Make Predictable Mistakes”
(with Sandra Klein), applies this framework to the problem of corporate
divestitures.
Chapter 4, “e Entrepreneurial Organization of Heterogeneous Capital”
(with Kirsten Foss, Nicolai Foss, and Sandra Klein), shows how
Austrian capital theory provides further insight into the firm’s existence,
boundaries, and internal organization. e Austrian idea that resources
are heterogeneous, that capital goods have what Lachmann (1956) called
“multiple specificities,” is hardly surprising to specialists in strategic management,
a literature that abounds with notions of unique “resources,”
“competencies,” “capabilities,” “assets,” and the like. But modern theories
of economic organization are not built on a unified theory of capital
heterogeneity, simply invoking ad hoc specificities when necessary. e
Misesian concept of the capital-owning entrepreneur, seeking to arrange
his unique resources into value-adding combinations, helps illuminate

x
several puzzles of firm organization.
Management scholars, and some economists, are familiar with Israel
Kirzner’s concept of entrepreneurship as “discovery,” or “alertness” to
profit opportunities, typically seeing it as “the” Austrian approach of
entrepreneurship. Kirzner, Mises’s student at NYU, has always described
his approach to entrepreneurship as a logical extension of Mises’s ideas.
However, as I argue in chapter 5, “Opportunity Discovery and Entrepreneurial
Action,” one can interpret Mises differently. Indeed, I see
Mises’s approach to the entrepreneur as closer to Frank Knight’s (1921),
a view that makes asset ownership, and the investment of resources under
uncertainty, the hallmark of entrepreneurial behavior. is suggests a
focus not on opportunities, the subjective visions of entrepreneurs, but
on investment—on actions, in other words, not beliefs. I suggest several
implications of this approach for applied entrepreneurship research. Chapter
6, “Risk, Uncertainty, and Economic Organization,” written for the
Hoppe Festschrift (Hülsmann and Kinsella, 2009), further discusses the
Knightian distinction between “risk” and “uncertainty,” or what Mises
called “class probability” and “case probability.”
Chapter 7, “Price eory and Austrian Economics,” challenges what
I see as the dominant understanding of the Austrian tradition, particularly
in applied fields like organization and strategy. Scholars both
inside and outside economics tend to identify the Austrian school with
Hayek’s ideas about dispersed, tacit knowledge, Kirzner’s theory of entrepreneurial
discovery, and an emphasis on time, subjectivity, process, and
disequilibrium. Despite renewed interest in the Mengerian tradition,
the Austrian approach to “basic” economic analysis—value, production,
exchange, price, money, capital, and intervention—hasn’t gotten much
attention at all. Indeed, it’s widely believed that the Austrian approach
to mundane topics such as factor productivity, the substitution effect of
a price change, the effects of rent control or the minimum wage, etc., is
basically the same as the mainstream approach, just without math or with
a few buzzwords about“subjectivism” or the “market process” thrown in.
Even many contemporary Austrians appear to hold this view. Chapter 7
suggests instead that the Austrians offer a distinct and valuable approach to
basic economic questions, an approach that should be central to research
by Austrians on theoretical and applied topics in economics and business
administration.

xi
A final chapter, “Commentary,” collects some shorter essays on the
nature and history of the Internet, the role of the intellectuals in society,
the relationship between management theory and the business cycle,
biographical sketches of Carl Menger and F. A. Hayek, and a note on
Williamson’s contributions and his relationship to the Austrian tradition.
Some of these first appeared as Daily Articles at Mises.org and were written
for a nonspecialist audience. Indeed, I think scholars in every field,
particularly in economics and business administration, have an obligation
to write for the general public, and not only for their fellow specialists.
Ideas have consequences, as Richard Weaver put it, and economic ideas
are particularly important.
In preparing these essays for publication in book form I have made
only light revisions in the text, correcting minor errors, eliminating some
redundant material, and updating a few references. I think they work well
together, and I hope readers will see the end result as an integrated whole,
not simply a collection of “greatest hits.”
I’ve been greatly influenced and helped by many friends, teachers, colleagues,
and students, far too many to list here. ree people deserve special
mention, however. From my father, Milton M. Klein, a historian who
taught at Columbia University, Long Island University, SUNY–Fredonia,
New York University, and the University of Tennessee, I learned the craft
and discipline of scholarship. He taught me to read critically, to think and
write clearly, to take ideas seriously. Murray Rothbard, the great libertarian
polymath whose life and work played such a critical role in the modern
Austrian revival, dazzled me with his scholarship, his energy, and his sense
of life. Rothbard is widely recognized as a great libertarian theorist, but his
technical contributions to Austrian economics are not always appreciated,
even in Austrian circles. In my view he is one of the most important
contributors to the “mundane” Austrian analysis described above. Oliver
Williamson, who supervised my PhD dissertation at Berkeley, is my most
important direct mentor and a constant source of inspiration. Williamson
is no Austrian, but he appreciated and supported my interest in the Austrian
school and encouraged me to pursue my intellectual passions, not to
follow the crowd. His encouragement and support have been critical to
my development as a scholar.
I’m deeply grateful to the Contracting and Organizations Research
Institute, the University of Missouri’s Division of Applied Social Sciences,

xii
the University of Missouri Research Foundation, the Coase Foundation,
the Kauffman Foundation, and, above all, the Mises Institute for generous
financial and moral support over the years. I’ve learned so much from my
university colleagues, coauthors, fellow bloggers, conference participants,
and other members of the Academic Racket that it would be impossible
to name all those who’ve influenced my work. My frequent coauthor
Nicolai Foss, who thinks and writes more quickly than I can listen
or read, keeps me on my toes. I’ve learned much about Austrian economics,
firm strategy, economic organization, and a host of other topics
from Joseph Salerno, Lasse Lien, Joseph Mahoney, Dick Langlois, Michael
Cook, Michael Sykuta, and many others. Others who offered specific
comments and suggestions on earlier versions of these chapters include
Sharon Alvarez, Jay Barney, Randy Beard, Don Boudreaux, Per Bylund,
John Chapman, Todd Chiles, Jerry Ellig, David Gordon, Jeff Herbener,
Stavros Ioannides, Dan Klein, Mario Mondelli, Jennie Raymond, David
Robinson, Fabio Rojas, Ron Sanchez, Ivo Sarjanovic, Narin Smith, Sid
Winter, and Ulrich Witt. My colleagues have also tried to teach me about
deadlines, but I’m still working on that one. I agree with Douglas Adams,
“I love deadlines. I like the whooshing sound they make as they fly by.”
Special thanks go to Doug French for suggesting this project and to
Jeff Tucker, Arlene Oost-Zinner, Paul Foley, and Per Bylund for seeing it
to fruition. Most important, I thank my wife Sandy and my children for
putting up with my frequent absences, endless hours in front of a computer
screen, and occasional irritability. ey are my greatest inspiration.
Peter G. Klein
Columbia, Missouri
March 2010

CHAPTER 1
Economic Calculation and the Limits of
Organization †
Economists have become increasingly frustrated with the textbook model
of the firm. e “firm” of intermediate microeconomics is a production
function, a mysterious “black box” whose insides are off-limits to
respectable economic theory (relegated instead to the lesser disciplines of
management, organization theory, industrial psychology, and the like).
ough useful in certain contexts, the textbook model has proven unable
to account for a variety of real-world business practices: vertical and lateral
integration, geographic and product-line diversification, franchising, longterm
commercial contracting, transfer pricing, research joint ventures, and
many others. As an alternative to viewing the firm as a production function,
economists are turning to a new body of literature that views the
firm as an organization, itself worthy of economic analysis. is emerging
literature is the best-developed part of what has come to be called the
“new institutional economics. 1 e new perspective has deeply enhanced
† Published originally in Review of Austrian Economics 9, no. 2 (1996): 51–77.
1 For overviews of the new institutional economics and the theory of the firm, see Coase
(1991); Holmström and Tirole (1989); Langlois (1994b); Furubotn and Richter (1997);
Williamson (2000); Ménard and Shirley (2005), and Brousseau and Glachant (2008). For
surveys of related empirical work see Shelanski and Klein (1995); Klein (2005), and Macher
and Richman (2008).
1

2
and enriched our understanding of firms and other organizations, such
that we can no longer agree with Ronald Coase’s 1988 statement that
“[w]hy firms exist, what determines the number of firms, what determines
what firms do . . . are not questions of interest to most economists”
(Coase, 1988, p. 5). e new theory is not without its critics; Richard
Nelson (1991), for example, objects that the new institutional economics
tends to downplay discretionary differences among firms. Still, the new
institutional economics—in particular, agency theory and transaction cost
economics—has been the subject of increasing attention in industrial organization,
corporate finance, strategic management, and business history. 2
is chapter highlights some distinctive Austrian contributions to the
theory of the firm, contributions that have been largely neglected, both
inside and outside the Austrian literature. In particular, I argue that Mises’s
concept of economic calculation—the means by which entrepreneurs adjust
the structure of production to accord with consumer wants—belongs
at the forefront of Austrian research into the nature and design of organizations.
ere is a unique Austrian perspective on economic planning,
a perspective developed over the course of the socialist calculation
debate. As was recognized in the early Austrian reinterpretations of the
calculation debate (Lavoie, 1985; Kirzner, 1988a), Mises’s conception of
the problem faced by socialist planners is part and parcel of his understanding
of how resources are allocated in a market system. Mises himself
emphasized that planning is ubiquitous: “[E]very human action means
planning. What those calling themselves planners advocate is not the
substitution of planned action for letting things go. It is the substitution
of the planner’s own plan for the plans of his fellow men” (Mises, 1947,
p. 493). All organizations plan, and all organizations, public and private,
perform economic calculation. In this sense, the calculation problem is
much more general than has usually been realized.
With their unique perspective on markets and the difficulties of resource
allocation under central planning, third- and fourth-generation
Austrian economists have always implicitly understood the economics
of organization. In this context, as Nicolai Juul Foss (1994a, p. 32)
2 e framework of transaction cost economics has already made it into textbook
form: Kreps (1990b, pp. 744–90), Rubin (1990), Milgrom and Roberts (1992), Acs and
Gerlowski (1996), Brickley, Smith, and Zimmerman (1997), and Besanko, Dranove, and
Shanley (1998).

3
notes, “it is something of a doctrinal puzzle that the Austrians have never
formulated a theory of the firm.” Foss points out that many elements
of the modern theory of the firm—property rights, relationship-specific
assets, asymmetric information, the principal–agent problem—appeared,
at least in elementary form, in Austrian writings since the middle stages
of the calculation debate. Indeed, Rothbard’s treatment of firm size
in Man, Economy, and State (1962) was among the first discussions to
adopt explicitly the framework proposed by Ronald Coase in 1937, a
framework that underlies most contemporary theorizing about the firm.
Mises’s discussion in Human Action (1949) of the role of the financial
markets foreshadows Henry Manne’s seminal 1965 article on the market
for corporate control along with the recent recognition of finance as an
essential part of economics.
Besides anticipating parts of the modern literature, Mises and Rothbard
also introduced significant innovations, though this has not yet been
generally recognized. eir contributions, while not part of a fully articulated,
explicit theory of the firm, deserve attention and development, especially
by those working on such issues from within the Austrian School. 3
ese contributions are Rothbard’s application of the calculation problem
to the limits of the firm, and Mises’s discussion of how the financial markets
both limit managerial discretion and perform the ultimate resource
allocation task in a market economy.
The Textbook Theory of the Firm
In neoclassical economic theory, the firm as such does not exist at all. e
“firm” is a production function or production possibilities set, a means of
transforming inputs into outputs. Given the available technology, a vector
of input prices, and a demand schedule, the firm maximizes money profits
subject to the constraint that its production plans must be technologically
feasible. at is all there is to it. e firm is modeled as a single actor,
facing a series of relatively uncomplicated decisions: what level of output
to produce, how much of each factor to hire, and so on. ese “decisions,”
of course, are not really decisions at all; they are trivial mathematical calculations,
implicit in the underlying data. In the long run, the firm may also
3 Foss and Klein (2010) summarize some of this literature.

4
choose an optimal size and output mix, but even these are determined by
the characteristics of the production function (economies of scale, scope,
and sequence). In short: the firm is a set of cost curves, and the “theory of
the firm” is a calculus problem.
To be sure, these models are not advertised as realistic descriptions of
actual business firms; their use is purely instrumental. As David Kreps
(1990b, p. 233)—himself much less sanguine about the merits of the traditional
model than most—puts it: if real-world firms do not maximize
profits as the traditional theory holds, “that doesn’t mean that profit maximization
isn’t a good positive model. Only the data can speak to that,
and then only after we see the implications of profit maximization for
observable behavior.” However, even granting instrumentalism its somewhat
dubious merits, 4 the production-function approach is unsatisfactory,
because it isn’t useful for understanding a variety of economic phenomena.
e black-box model is really a theory about a plant or production process,
not about a firm. A single firm can own and operate multiple production
processes. Similarly, two or more firms can contract to operate jointly a
single production process (as in a research joint venture). If we want to
understand the scale and scope of the firm as a legal entity, then, we must
look beyond the textbook model.
Coase and Transaction Costs
Ronald Coase, in his celebrated 1937 paper on “e Nature of the Firm,”
was the first to explain that the boundaries of the organization depend not
only on the productive technology, but on the costs of transacting business.
In the Coasian framework, as developed and expanded by Williamson
(1975, 1985, 1996), Klein, Crawford, and Alchian (1978), and Grossman
and Hart (1986), the decision to organize transactions within the firm as
opposed to on the open market—the “make or buy decision”—depends on
the relative costs of internal versus external exchange. e market mechanism
entails certain costs: discovering the relevant prices, negotiating and
4 For critiques of instrumentalism see Rizzo (1978) and Batemarco (1985). For references
to the interpretative literature on Milton Friedman’s 1953 essay on “positive economics”—the
source of most economists’ views on method—see Boland (1979), Caldwell
(1980), and Musgrave (1981); all reprinted in Caldwell (1984) along with De Marchi
(1988).

5
enforcing contracts, and so on. Within the firm, the entrepreneur may
be able to reduce these “transaction costs” by coordinating these activities
himself. However, internal organization brings another kind of transaction
cost, namely problems of information flows, incentives, monitoring, and
performance evaluation. e boundary of the firm, then, is determined
by the tradeoff, at the margin, between the relative transaction costs of
external and internal exchange. In this sense, firm boundaries depend not
only on technology, but on organizational considerations; that is, on the
costs and benefits of contracting.
e relative costs of external and internal exchange depend on particular
characteristics of transaction: the degree to which relationship-specific
assets are involved, the amount of uncertainty about the future and about
trading partners’ actions, the complexity of the trading arrangement, and
the frequency with which the transaction occurs. Each matters in determining
the preferred institutional arrangement (that is, internal versus
external production), although the first—“asset specificity”—is held to
be particularly important. Williamson (1985, p. 55) defines asset specificity
as “durable investments that are undertaken in support of particular
transactions, the opportunity cost of which investments are much lower in
best alternative uses or by alternative users should the original transaction
be prematurely terminated.” is could describe a variety of relationshipspecific
investments, including both specialized physical and human capital,
along with intangibles such as R&D and firm-specific knowledge or
capabilities.
Economic Calculation and the Limits to Firm Size
Unfortunately, the growing economics literature on the theory of the firm
focuses mostly on the costs of market exchange, and much less on the
costs of governing internal exchange. e new research has yet to produce
a fully satisfactory explanation of the limits to firm size (Williamson, 1985,
chap. 6). In Coase’s words, “Why does the entrepreneur not organize one
less transaction or one more?” Or, more generally, “Why is not all production
carried on in one big firm?” (Coase, 1937, pp. 393–94). e theory of
the limits to the firm is perhaps the most difficult and least well developed
part of the new economics of organization. Existing contractual explanations
rely on problems of authority and responsibility (Arrow, 1974);

6
incentive distortions caused by residual ownership rights (Grossman and
Hart, 1986; Hart and Moore, 1990; Hart, 1995); and the costs of attempting
to reproduce market governance features within the firm (Williamson,
1985, chap. 6). It is here that Austrian theory has an obvious contribution
to make, by applying Mises’s theorem on the impossibility of economic
calculation under socialism. Rothbard has shown how the need for monetary
calculation in terms of actual prices not only explains the failures of
central planning under socialism, but places an upper bound on firm size.
The Socialist Calculation Debate: A Brief Review
To understand Mises’s position in the calculation debate, one must realize
that his argument is not exclusively, or even primarily, about socialism. It
is about the role of prices for capital goods. Entrepreneurs make decisions
about resource allocation based on their expectations about future prices,
and the information contained in present prices. To make profits, they
need information about all prices, not only the prices of consumer goods
but the prices of factors of production. Without markets for capital goods,
these goods can have no prices, and hence entrepreneurs cannot make
judgments about the relative scarcities of these factors. In short, resources
cannot be allocated efficiently. In any environment, then—socialist or
not—where a factor of production has no market price, a potential user of
that factor will be unable to make rational decisions about its use. Stated
this way, Mises’s claim is simply that efficient resource allocation in a
market economy requires well-functioning asset markets. Because scholars
differ about what Mises “really meant,” however, it may be useful here to
provide a brief review of the debate.
Before 1920, according to the standard account, 5 socialist theorists
paid little attention to how a socialist economy would work in practice,
most heeding Marx’s admonition to avoid such “utopian” speculation.
en Mises, known at the time mainly as a monetary theorist, published
the sensational article later translated as “Economic Calculation in the
Socialist Commonwealth” (1920). 6 Mises claimed that without private
5 For examples of the “standard account” of the calculation debate see Schumpeter
(1942, pp. 172–86) and Bergson (1948). My discussion of the “revisionist view” follows
Hoff (1949), Salerno (1990a), and Rothbard (1991).
6 Other works that made arguments similar to that of Mises include N. G. Pierson’s

7
ownership of the means of production, there would be no market prices
for capital goods, and therefore no way for decision-makers to evaluate
the relative efficiency of various production techniques. Anticipating the
later argument for “market socialism,” Mises argued that even if there
were markets for consumer goods, a central planner could not “impute”
meaningful prices to capital goods used to produce them. In short, without
market-generated prices for both capital and consumer goods, even the
most dedicated planner would find it “impossible” to allocate resources
according to consumer wants.
roughout the 1920s and early 1930s Mises’s argument became the
focus of intense discussion within the German-language literature. Eventually
it was agreed that Mises was correct at least to point out that a
socialist society could not do without such things as money and prices,
as some early socialists had suggested, and that there was no feasible way
to set prices according, say, to quantities of labor time. Nonetheless, it
was felt that Vilfredo Pareto and his follower Enrico Barone (1908) had
shown that nothing was “theoretically” wrong with socialism, because the
requisite number of demand and supply equations to make the system
“determinate” would exist under either capitalism or socialism. If the
planners could somehow get the necessary information on preferences and
technology, they could in principle compute an equilibrium allocation of
final goods.
e most important response to Mises, however, and the one almost
universally accepted by economists, was what became known as “market
socialism” or the “mathematical solution,” developed by Fred Taylor
(1929), H. D. Dickinson (1933), Abba Lerner (1934), and Oskar Lange
(1936–37). In a system of market socialism, capital goods are collective
property, but individuals are free to own and exchange final goods and
services. e system would work like this. First, the Central Planning
Board chooses arbitrary prices for consumer and capital goods. At those
prices, the managers of the various state-owned enterprises are instructed
to produce up to the point where the marginal cost of each final good is
equal to its price, and then to choose the input mix that minimizes the
average cost of producing that quantity. en, consumer goods prices are
“e Problem of Value in the Socialist Community” (1902) and parts of Max Weber’s
Economy and Society (1921).

8
allowed to fluctuate, and the Central Planning Board adjusts the prices of
capital goods as shortages and surpluses of the final goods develop. Resources
would thus be allocated according to supply and demand, through
a process of “trial-and-error” essentially the same as that practiced by the
managers of capitalist firms. Lange’s contribution, it has generally been
held, was to show that production under market socialism could be just
as efficient as production under capitalism, since the socialist planners
“would receive exactly the same information from a socialized economic
system as did entrepreneurs under a market system” (Heilbroner, 1970,
p. 88). 7
Market socialism was seen as an answer not only to Mises’s calculation
problem, but also to the issue of “practicality” raised by Hayek and Lionel
Robbins. Hayek, in his contributions to Collectivist Economic Planning
(Hayek, 1935), later expanded in “e Competitive Solution” (1940) and
his well-known papers “Economics and Knowledge” (1937) and “e Use
of Knowledge in Society” (1945), and Robbins, in his e Great Depression
(1934), had changed the terms of the debate by focusing not on the
problem of calculation, but on the problem of knowledge. For Hayek
and Robbins, the failure of socialist organization is due to a mechanism
design problem, in that planners cannot allocate resources efficiently because
they cannot obtain complete information on consumer preferences
and resource availability. Furthermore, even if the planners were somehow
able to acquire these data, it would take years to compute the millions of
prices used by a modern economy. e Lange–Lerner–Taylor approach
claimed to solve this preference-revelation problem by trial-and-error, so
no actual computations would be necessary. 8
7 It would no doubt be gratuitous to point out that since the collapse of central planning
in Eastern Europe the writer of that comment has changed his mind, writing that although
fifty years ago, it was felt that Lange had decisively won the argument for socialist planning,
“now it turns out, of course, that Mises was right” (Heilbroner, 1990, p. 92).
8 Lange actually claimed years later that even market socialism would be made obsolete
with the advent of high-speed computers, which could instantly solve the huge system of
simultaneous equations for the central planner. “Were I to rewrite my [1936] essay today
my task would be much simpler. My answer to Hayek and Robbins would be: So what’s
the trouble? Let us put the simultaneous equations on an electronic computer and we
shall obtain the solution in less than a second. e market process with its cumbersome
tâtonnements appears old-fashioned. Indeed, it may be considered as a computing device of
the pre-electronic age” (Lange, 1965, pp. 401–02). Obviously, Lange did not have much

9
With the widespread acceptance of the theory of market socialism,
there developed an “orthodox line” on the socialist calculation debate,
neatly summarized in Abram Bergson’s well-known survey of “Socialist
Economics” (1948) and in Joseph Schumpeter’s Capitalism, Socialism and
Democracy (1942, pp. 172–86). According to this line, Mises first raised
the problem of the possibility of economic calculation under socialism,
only to be refuted by Pareto and Barone; Hayek and Robbins then “retreated”
to the position that socialist planners could calculate in theory,
but that in practice the information problem would make this too difficult;
then the market socialists showed that trial and error would eliminate the
need for complete information on the part of the planners. erefore, the
argument goes, economic theory per se can say nothing conclusive about
the viability of central planning, and the choice between capitalism and
socialism must be purely political.
Calculation versus Incentives
e orthodox line on socialist planning has been modified in recent years
with the development of incentive and information theory. e differences
between capitalism and socialism, it is now typically held, lie in the different
incentive properties of the two systems. Centrally directed systems
are thought to be subject to greater agency costs—managerial discretion,
shirking, and so on—than market systems (see, for example Winiecki,
1990). After all, Lange himself warned that “the real danger of socialism
is that of a bureaucratization of economic life” (Lange, 1936–37, p. 109;
italics in original).
As has been pointed out elsewhere (Rothbard, 1991, pp. 51–52), however,
the calculation debate was not primarily about agency or managerial
incentives. e incentive problem had long been known 9 (if not fully developed)
and was expressed in the famous question: “Under socialism, who
will take out the garbage?” at is, if everyone is compensated “according
to his needs,” what will be the incentive to do the dirty and unpleasant
experience with a computer. Also, during his time as chairman of the Polish Economic
Council in the 1950s, Lange never tried to put market socialism into practice (see Lange,
1958).
9 We tend to forget just how old the idea of socialism is, that it is not a twentieth-century
invention; the subtitle of Alexander Gray’s famous book e Socialist Tradition (1946) is
“Moses to Lenin.”

10
tasks; or, for that matter, any tasks at all? e traditional socialist answer
was that self-interest is a product of capitalism, and that socialism would
bring about a change in human nature. In the worker’s paradise would
emerge a “New Socialist Man,” eager to serve and motivated only by the
needs of his fellows. ese early theorists seem to have assumed, to borrow
the expression used by Oliver Williamson (1991a, p. 18) in a critique of a
more recent socialist proposal, “the abolition of opportunism by agencies
of the state.” Experience has exposed the charming naiveté of such notions.
But Mises’s challenge to socialism is distinct from this well-known
incentive problem. 10 Assume for the moment that everyone is willing to
work just as hard under central direction as under a market system. ere
still remains the problem of exactly what directives the Central Planning
Board will issue. e Board will have to decide what goods and services
should be produced, how much of each to produce, what intermediate
goods are needed to produce each final good, and so on. In a complex,
modern economy with multiple stages of production, resource allocation
requires the existence of money prices for capital goods, prices that under
capitalism arise from an ongoing process of competitive bidding by entrepreneurs
for the factors of production. is process cannot be replicated by
input-output analysis, computer simulations, or any other form of artificial
market. Mises’s main point was that socialism fails because decision makers
require meaningful prices for all of these factors to choose from the vast
array of possible factor combinations. “Without recourse to calculating
and comparing the benefits and costs of production using the structure of
monetary prices determined at each moment on the market, the human
mind is only capable of surveying, evaluating, and directing production
processes whose scope is drastically reduced to the compass of the primitive
household economy” (Salerno, 1990a, p. 52).
e distinction between calculation and incentives is important because
the modern economics literature on organizational design—from
transaction cost explanations of firm size, to public choice theories of bureaucracy,
to recent work on market socialism and the “soft budget constraint”
(Kornai, 1986)—focuses primarily on incentive problems (possi-
10 Mises does devote a section of the 1920 paper to “Responsibility and Initiative in
Communal Concerns,” but he clearly considers this a secondary problem for socialist
planners, not the primary one. In the book-length treatment, Socialism (1922), Mises
discusses the incentive problem in greater detail (pp. 163–84).

11
bly encouraged by Lange’s famous warning about bureaucracy). Incentive
theory asks how, within a specified relationship, a principal can get an
agent to do what he wants him to do. Mises’s problem, however, was
different: How does the principal know what to tell the agent to do? at
is, just what activities ought to be undertaken? What investments should
be made? Which product lines expanded and which ones contracted? e
ideas developed in the calculation debate suggest that when organizations
are large enough to conduct activities that are exclusively internal—so that
no reference to the outside market is available—they will face a calculation
problem as well as an incentive problem.
In this sense, market-socialist proposals are mostly irrelevant to the real
problems of socialist organization. is is the case Mises himself sought to
make in his critique of market socialism in Human Action (Mises, 1949,
pp. 694–711). ere he complained that the market socialists—and, for
that matter, all general equilibrium theorists—misconceive the nature of
“the economic problem.” Lange, Lerner, and Taylor looked primarily at
the problem of consumer goods pricing, while the crucial problem facing
a modern economy concerns the capital structure: namely, in what
way should capital be allocated to various activities? e market economy,
Mises argued, is driven not by “management”—the performance of
specified tasks, within a framework given to the manager—but by entrepreneurship,
the speculation, arbitrage, and other risk-bearing activities
that determine just what the managerial tasks are. It is not managers but
entrepreneurs, acting in the capital and money markets, who establish and
dissolve corporations, create and destroy product lines, and so on. ese
are precisely the activities that even market socialism seeks to abolish. In
other words, to the extent that incentives are important, what socialism
cannot preserve are high-powered incentives not in management, but in
entrepreneurial forecasting and decision making.
Mises has been described as saying that it is unreasonable to expect
managers of socialist enterprises to “play market,” to act as if they were
managers of private firms where their own direct interests were at stake.
is may be true, but Mises’s prime concern was that entrepreneurs cannot
be asked to “play speculation and investment” (Mises, 1949, p. 705). e
relevant incentive problem, he maintains, is not that of the subordinate
manager (the agent), who takes the problem to be solved as given, but
that of the speculator and investor (the principal), who decides just what

12
is the problem to be solved. Lange, Lerner, and Taylor see the market
through a strictly static, neoclassical lens, where all the parameters of the
system are given and only a computational problem needs to be solved.
In fact the market economy is a dynamic, creative, evolving process, in
which entrepreneurs—using economic calculation—make industries grow
and shrink, cause new and different production methods to be tried and
others withdrawn, and constantly change the range of available products.
It is these features of market capitalism, and not the incentives of agents
to work hard, that are lost without private property ownership.
Indeed, traditional command-style economies, such as that of the
former USSR, appear to be able only to mimic those tasks that market
economies have performed before; they are unable to set up and execute
original tasks.
e [Soviet] system has been particularly effective when the
central priorities involve catching up, for then the problems of
knowing what to do, when and how to do it, and whether it was
properly done, are solved by reference to a working model, by exploiting
what Gerschenkron ... called the “advantage of backwardness.”
... Accompanying these advantages are shortcomings, inherent
in the nature of the system. When the system pursues a few
priority objectives, regardless of sacrifices or losses in lower priority
areas, those ultimately responsible cannot know whether the
success was worth achieving. e central authorities lack the information
and physical capability to monitor all important costs—in
particular opportunity costs—yet they are the only ones, given the
logic of the system, with a true interest in knowing such costs.
(Ericson, 1991, p. 21).
Without economic calculation, there is no way to figure out if tasks
have been performed efficiently. Hence without markets for physical
and financial capital—which determine what tasks will be performed and
whether they have been performed adequately—an economic system has
difficulty generating anything new, and must rely on outside references to
tell it what to do. Of course, the only reason the Soviet Union and the
communist nations of Eastern Europe could exist at all is that they never
fully succeeded in establishing socialism worldwide, so they could use
world market prices to establish implicit prices for the goods they bought
and sold internally (Rothbard, 1991, pp. 73–74). In Mises’s words, these
economies

13
were not isolated social systems. ey were operating in an environment
in which the price system still worked. ey could
resort to economic calculation on the ground of the prices established
abroad. Without the aid of these prices their actions would
have been aimless and planless. Only because they were able to
refer to these foreign prices were they able to calculate, to keep
books, and to prepare their much talked about plans. (Mises, 1949,
pp. 698–99).
As we will see below, the firm is in the same situation: it needs outside
market prices to plan and evaluate its actions.
Rothbard and the Limits of Organization
Rothbard’s main contribution to the theory of the firm was to generalize
Mises’s analysis of the problem of resource allocation under socialism to the
context of vertical integration and the size of the organization. Rothbard
writes in Man, Economy, and State that up to a point, the size of the firm
is determined by costs, as in the textbook model. But “the ultimate limits
are set on the relative size of the firm by the necessity for markets to exist
in every factor, in order to make it possible for the firm to calculate its
profits and losses” (Rothbard, 1962, p. 599). is argument hinges on the
notion of “implicit costs.” e market value of opportunity costs for factor
services—what Rothbard calls “estimates of implicit incomes”—can be determined
only if there are external markets for those factors (pp. 607–09).
For example, if an entrepreneur hires himself to manage his business, the
opportunity cost of his labor must be included in the firm’s costs. But without
an actual market for the entrepreneur’s managerial services, he will be
unable to figure out his opportunity cost; his balance sheets will therefore
be less accurate than they would if he could measure his opportunity cost.
e same problem affects a firm owning multiple stages of production.
A large, integrated firm is typically organized as groups of semiautonomous
business units or “profit centers,” each unit or division specializing
in a particular final or intermediate product. e central management
of the firm uses the implicit incomes of the business units, as
reflected in statements of divisional profit and loss, to allocate physical
and financial capital across the divisions. More profitable divisions are
expanded, while less profitable divisions are scaled back. Suppose the firm

14
has an upstream division selling an intermediate component to a downstream
division. To compute the divisional profits and losses, the firm
needs an economically meaningful “transfer price” for the component. If
there is an external market for the component, the firm can use that market
price as the transfer price. 11 Without a market price, however, a transfer
price must be estimated in another way.
In practice, this is typically done on a cost-plus basis; sometimes, the
buying and selling divisions are left free to bargain over the price (Eccles
and White, 1988; Shelanski, 1993; King, 1994). At the very least, any
artificial or substitute transfer prices will contain less information than
actual market prices; Rothbard (1962, p. 613) puts it more strongly, calling
a substitute price “only an arbitrary symbol.” In either case, firms relying on
these prices will suffer. “Not being able to calculate a price, the firm could
not rationally allocate factors and resources from one stage [or division] to
another” (Rothbard, 1962, p. 613) e use of internally traded intermediate
goods for which no external market reference is available introduces
distortions that reduce organizational efficiency. is gives us the element
missing from contemporary theories of economic organization, an upper
bound: the firm is constrained by the need for external markets for all
internally traded goods. In other words, no firm can become so large that
it is both the unique producer and user of an intermediate product; for
then no market-based transfer prices will be available, and the firm will
be unable to calculate divisional profit and loss and therefore unable to
allocate resources correctly between divisions. As Rothbard puts it:
Since the free market always tends to establish the most efficient
and profitable type of production (whether for type of good,
11 Rothbard (1962, pp. 612, n. 56) notes that the implicit transfer price may be somewhat
more or less than the existing market price, since the entry of either the buying
or the selling division into the external market may bid the price up or down slightly.
Unlike Hirshleifer (1956), then, Rothbard does not require the external market to be
perfectly competitive for a market-based transfer price to be economically meaningful. For
Rothbard, “thin” markets are adequate: all that is necessary to have a genuine “external
market” is the existence of at least one other producer (seller) of the intermediate good.
(Of course, if external prices are perfectly competitive, then the economy must be in a
competitive general equilibrium, in which information is perfect and all contracts are
complete, and in which there is thus no need for firms.) Rothbard does not discuss
the potential “holdup” problem that follows from relationship-specific investment under
bilateral monopoly (Klein, Crawford, and Alchian, 1978), which should be considered a
cost of reliance on an external market with a single supplier.

15
method of production, allocation of factors, or size of firm), we
must conclude that complete vertical integration for a capital-good
product can never be established on the free market (above the
primitive level). For every capital good, there must be a definite market
in which firms buy and sell that good. It is obvious that this economic
law sets a definite maximum to the relative size of any particular firm
on the free market.... Economic calculation becomes ever more
important as the market economy develops and progresses, as the
stages and the complexities of type and variety of capital goods
increase. Ever more important for the maintenance of an advanced
economy, then, is the preservation of markets for all the capital
and other producers’ goods. (Rothbard, 1962, p. 613; italics in
original)
Like the centrally planned economy, the firm needs market signals
to guide its actions; without them the firm cannot survive. Note that in
general, Rothbard is making a claim only about the upper bound of the
firm, not the incremental cost of expanding the firm’s activities (as long
as external market references are available). As soon as the firm expands
to the point where at least one external market has disappeared, however,
the calculation problem exists. e difficulties become worse as more and
more external markets disappear, as “islands of noncalculable chaos swell
to the proportions of masses and continents. As the area of incalculability
increases, the degrees of irrationality, misallocation, loss, impoverishment,
etc., become greater” (p. 548). In other words, the firm is limited by the
extent to which markets exist for the goods it allocates internally. Without
market prices for these goods, the firm must rely on relatively costly and
inefficient methods of generating its own accounting prices, to perform
internal calculations. 12
Significantly, it is at this point in the discussion in Man, Economy,
and State (p. 548) that Rothbard launches into a discussion of the socialist
calculation debate, making it obvious that the two issues are inextricably
linked. e reason that a socialist economy cannot calculate is not that
12 is does not mean that because external prices are necessary for large firms to function
efficiently, firms will necessarily become larger where external markets are “thick” or better
developed. On the contrary, large firms typically arise precisely where external markets
are poorly developed or hampered by government intervention; these are the kinds of
circumstances that give entrepreneurs an advantage in coordinating activities internally.
However, such firms are still constrained by the need for some external market reference.

16
it is socialist, but because a single agent owns and directs all resources.
Expanding on this point in his 1976 essay on “Ludwig von Mises and
Economic Calculation Under Socialism,” Rothbard explains:
ere is one vital but neglected area where the Mises analysis of
economic calculation needs to be expanded. For in a profound
sense, the theory is not about socialism at all! Instead, it applies to
any situation where one group has acquired control of the means
of production over a large area—or, in a strict sense, throughout
the world. On this particular aspect of socialism, it doesn’t matter
whether this unitary control has come about through the coercive
expropriation brought about by socialism or by voluntary processes
on the free market. For what the Mises theory focuses on is not simply
the numerous inefficiencies of the political as compared to the
profit-making market process, but the fact that a market for capital
goods has disappeared. is means that, just as socialist central
planning could not calculate economically, no One Big Firm could
own or control the entire economy. e Mises analysis applies
to any situation where a market for capital goods has disappeared
in a complex industrial economy, whether because of socialism or
because of a giant merger into One Big Firm or One Big Cartel.
(Rothbard, 1976, p. 75)
e Mises analysis thus applies to any situation where the market for a
particular capital good disappears because a firm has become so large that
it is the unique producer and user of that capital good. As we have seen,
such a firm will not be viable.
It is surprising that Rothbard’s extension of Mises’s argument has
received virtually no attention in the Austrian literature, even though
the point appears four times in Man, Economy, and State (p. 536, p. 543,
pp. 547–48, and p. 585) and again in the 1976 essay. 13 e argument
needs further development and elaboration, which should prove a useful
exercise because the contemporary literature on the size of the firm lacks an
13 Lavoie briefly notes the Rothbard analysis in his Rivalry and Central Planning (1985,
p. 62n). Fritz Machlup, in a comment on Rothbard’s 1976 essay, says he is “intrigued”
by the analogy between the central planner’s problem and the firm’s problem, calling it
“an issue I have tried to sell in several of my publications ... but unfortunately not with
sufficient success” (Machlup, 1976a, p. 114). He cites an early book (Machlup, 1934,
esp. pp. 209–14) and a later article (Machlup, 1974, esp. pp. 42–45 and 52–54), both
published in German, on the problem of “artificial” transfer prices. e argument is also
foreshadowed by Hayek in Prices and Production (1931, p. 63) in a discussion on vertical
integration.

17
adequate explanation for the limits to organization. e Rothbard analysis
also suggests a line of research in business strategy: all else equal, firms able
to use market-based transfer prices should outperform, in the long run,
firms using administered or negotiated transfer prices. 14 As of yet, there is
little empirical work on this topic, despite a growing interest in Austrian
economics within the strategic management field (Jacobson, 1992; Lewin
and Phelan, 1999; Foss and Mahnke, 2000; Langlois, 2001; Roberts and
Eisenhardt, 2003; Yu, 2003; Ng, 2005; Mathews, 2006).
A related issue that has received considerable attention, however, is the
difficulty of allocating overhead or fixed cost across divisions. If an input is
essentially indivisible (or nonexcludable), then there is no way to compute
the opportunity cost of just the portion of the input used by a particular
division (see Rogerson, 1992, for a discussion of these problems). 15 Firms
with high overhead costs should thus be at a disadvantage relative to firms
able to allocate costs more precisely between business units. Indeed, in the
literature on cost accounting there has been some recent interest in “market
simulation accounting” (Staubus, 1986), by which firms try to assess the
price at which an asset would trade in an active market, based on observed
market prices and related information. e Rothbardian position on the
limits to firm size suggests that the market simulation approach may prove
a useful accounting technique.
By the time of the 1976 paper, Rothbard had adopted an explicitly
Coasian framework in his discussion of the limits to firm size. His own
treatment, Rothbard says,
serves to extend the notable analysis of Professor Coase on the market
determinants of the size of the firm, or the relative extent of
corporate planning within the firm as against the use of exchange
and the price mechanism. Coase pointed out that there are diminishing
benefits and increasing costs to each of these two alternatives,
resulting, as he put it, in an “ ‘optimum’ amount of planning” in
14 is line of reasoning has interesting implications for the study of innovation. Since
the innovating firm is more likely to be using unique intermediate goods, particularly in
industries where few of the relevant manufacturing capabilities exist in the market (Langlois
and Robertson, 1995), innovation carries with its benefits the cost of more severe internal
distortions. Economic calculation is then another obstacle the innovator must overcome.
15 Mises (1944, p. 32) recognized the problem of allocating overhead costs, mentioning
this as a possible exception to the notion that divisional accounting costs can reflect “true”
costs.

18
the free market system. Our thesis adds that the costs of internal
corporate planning become prohibitive as soon as markets for
capital goods begin to disappear, so that the free-market optimum
will always stop well short not only of One Big Firm throughout
the world market but also of any disappearance of specific markets
and hence of economic calculation in that product or resource.
(Rothbard, 1976, p. 76)
is is noteworthy because even as late as 1972, Coase was describing
his 1937 paper as “much cited and little used” (Coase, 1972, p. 62).
Alchian and Demsetz’s “Production, Information Costs, and Economic
Organization” came out only in 1972, and Williamson’s Markets and Hierarchies
in 1975. Rothbard was thus among the earliest writers to develop
and extend the Coasian perspective.
Alternative Austrian Approaches
ere is some debate within the Austrian literature about whether the basic
Coasian approach is compatible with Austrian economics. O’Driscoll
and Rizzo (1985, p. 124), while acknowledging Coase’s approach as an
“excellent static conceptualization of the problem,” argue that a more evolutionary
framework is needed to understand how firms respond to change.
Some Austrian economists have suggested that the Coasian framework
may be too narrow, too squarely in the general-equilibrium tradition to
deal adequately with Austrian concerns (Boudreaux and Holcombe, 1989;
Langlois, 1994a). ey contend that the contemporary theory of the firm,
following Coase, retains the perspective of static equilibrium analysis and
profit maximization over a fixed set of outcomes with known probabilities.
As an alternative, some writers propose the framework in Frank
Knight’s Risk, Uncertainty, and Profit (1921). e Knightian framework,
they argue, offers genuine uncertainty, disequilibrium and process analysis,
and thus a scope for real entrepreneurship—aspects purportedly more
congenial to Austrians. “e Coasian and Knightian theories of the firm
deal with the issue [of the existence of firms] from two different vantage
points. e Coasian theory takes the inputs and outputs in the firm’s
production process as given, and models the firm as an organization that
acts to minimize the costs of transforming these inputs into outputs....
However, in Knight’s model, entrepreneurship is the primary role of the

19
firm (Boudreaux and Holcombe, 1989, p. 152). Williamson’s transaction
cost economics, as characterized by Langlois (1994a, p. 175), does broaden
the notion of cost minimization to include transaction costs as well as production
costs, but it remains essentially a static exercise with a limited role
for expectations: “Seldom does the theory give thought to the possibility
that organizational forms may be influenced as much by environments that
exist only as future possibilities, imagined or feared.”
To be sure, the Knightian concept of the profit-seeking entrepreneur,
investing resources under uncertainty, is one of the great contributions
to the theory of the firm. As discussed in chapters 4, 5, and 6 below, it
is close to Mises’s concept of the entrepreneur (closer, in my view, than
Israel Kirzner’s understanding of entrepreneurship). Still, these critiques
of the Coasian framework paint with too broad a brush; as Foss (1993c)
points out, there are “two Coasian traditions.” One tradition, the nexus-ofcontracts
branch associated with Alchian and Demsetz (1972), studies the
design of ex ante mechanisms to limit shirking when supervision is costly.
Here the emphasis is on monitoring and incentives in an (exogenously
determined) moral-hazard relationship. e aforementioned criticisms
may apply to this branch of the modern literature, but they do not apply
to the other tradition, the governance or asset-specificity branch, especially
in Williamson’s more heterodox formulation. Williamson’s transaction
cost framework incorporates non-maximizing behavior (bounded rationality);
true, “structural” uncertainty or genuine surprise (complete contracts
are held not to be feasible, meaning that all ex post contingencies cannot
be contracted upon ex ante); and process or adaptation over time (trading
relationships develop over time, typically undergoing a “fundamental
transformation” that changes the terms of trade). In short, “at least some
modern theories of the firm do not at all presuppose the ‘closed’ economic
universe—with all relevant inputs and outputs being given, human action
conceptualized as maximization, etc., that [some critics] claim are
underneath the contemporary theory of the firm” (Foss, 1993a, p. 274).
Stated differently, one can adopt an essentially Coasian perspective without
abandoning the Knightian or Austrian view of the entrepreneur as an
uncertainty-bearing, innovating decision-maker. 16
16 Nor do all Coasian perspectives deny the importance of specialized knowledge lines
in determining a firm’s capabilities or “core competence.” Transaction cost economics, for
example, simply holds that the need for ex post governance of contracts in the presence

20
Similarly, the approach described in this chapter differs from that advanced
in the literature on “market-based management” (Ellig, 1993; Ellig
and Gable, 1993; Koch, 2007). Market-based management is the philosophy
that firm success depends critically on the ability to replicate marketlike
features within the organization. One of these is “internal markets”
for intermediate goods (and services such as financial, legal, accounting,
and R&D support) along with the establishment of strict profit-center
divisions. Like market prices, these internal prices convey information
about local circumstances. Other features include an explicit “mission”
or recognition of the firm’s core competence, clearly defined roles and
responsibilities for lower-level employees (analogous to property rights in
a market economy), employee rewards based on performance (a profitand-loss
system), a well-defined “corporate culture” (customs, behavioral
norms), and decentralized decision making.
Underlying market-based management is the team-production or
nexus-of-contracts model of the firm advanced by Alchian and Demsetz
(1972), supplemented with the “capabilities” theory of Edith Penrose
(1959), G. B. Richardson (1972), David Teece (1980; 1982), and others.
But the market-based management literature, like other writings
in the nexus-of-contracts tradition, appears to mischaracterize the nature
of “planning” within the firm. For example, it attributes to the
Coase–Williamson tradition the view that “internal markets are doomed to
failure, because the business firm is by nature a command hierarchy” (Ellig,
1993, p. 9). e Coasian tradition, however, does not imply that firms
do or should adopt a command-and-control structure; on the contrary,
as we have already seen, the modern firm will tend to be significantly
decentralized, so that managers and workers at all levels of operations can
make use of local knowledge. All decisions are not made from above,
by executive fiat; the “M-form” corporation described by Williamson
and Chandler is a blend of market and hierarchy, of centralization and
decentralization.
In other words, the entrepreneur does make some decisions by “fiat”;
the firm is definitely a taxis, rather than a cosmos (to use Hayek’s esoteric
of relationship-specific investments, and not “tacit knowledge” per se, is the most useful
way to think about the boundaries of the firm. For the case that Austrian economics is
more compatible with the capabilities literature (for substantive, not only methodological,
reasons), see Minkler (1993b) and Langlois (1994a).

21
terminology). 17 is does not imply, however, that all decisions must
be made from the top; we can agree with the market-based management
literature that “neither central planning nor command-and-control are the
defining characteristics of a business firm” (Ellig, 1993, p. 11). Indeed,
given competition in the product and factor markets, firms will always
tend to select the optimum amount of “market-like” features. e firm’s
problem, then, is not too much “conscious” planning; the crucial issue
is whether these plans are made, and tested, from within a larger market
setting. e entrepreneur’s plans can be carried out, as we saw above, only
when there are definite markets for all internally traded goods or activities.
What firms need is not necessarily internal markets, but the information
generated by market prices.
Conclusion
is chapter has highlighted some Austrian contributions to the theory
of the firm and suggested directions for future research along the same
lines. In particular, Rothbard’s argument about the need for markets in
intermediate goods, and how that places limits on the scale and scope of
the organization, deserves further development. e chapter also points
the way toward an Austrian approach that makes the entrepreneur, and
his acts of resource allocation using monetary calculation, central to the
theory of the firm.
17 See also Tullock (1969).

CHAPTER 2
Entrepreneurship and Corporate Governance †
In his “closing salvo” in the socialist calculation debate, Mises (1949,
pp. 694–711) argued that the market socialists failed to understand the
role of financial markets in an industrial economy. Even with markets
for consumer goods, he explained, socialism would fail because it substituted
collective ownership of the means of production for private capital
markets. rough these markets, owners of financial capital decide which
firms, and which industries, receive resources to make consumer goods.
In a modern economy, most production takes place in publicly held
corporations. Of prime importance, then, is the problem of corporate
governance: How do owners of financial capital structure their agreements
with those who receive that capital, to prevent its misuse? Unfortunately,
there exists little research in this area from an Austrian perspective.
In this chapter, I focus on the financial-market entrepreneur—what
Rothbard (1962, 1985) calls the capitalist-entrepreneur—to outline some
features of an Austrian theory of corporate governance. I begin by reviewing
the traditional, production-function theory of the firm and suggesting
two alternative perspectives: that of the entrepreneur and that of the
† Published originally in Quarterly Journal of Austrian Economics 2, no. 2 (Summer
1999): 19–42. A Spanish translation, “Función empresarial y control de la dirección de le
empresa,” appeared in Libertas 16, no. 31 (October 1999): 3–49.
23

24
capitalist. I next discuss the Coasian, or “contractual” approach to the
firm and argue that it provides a useful organizing framework for Austrian
research on the firm. e subsequent section proposes entrepreneurship
and economic calculation as building blocks for an Austrian theory of
the firm. Finally, after a brief review of capital-market behavior and the
disciplinary role of takeovers, I outline four areas for Austrian research
in corporate governance: firms as investments, internal capital markets,
comparative corporate governance, and financiers as entrepreneurs.
Limits of the Standard Approach to the Firm
As we saw in chapter 1, the “firm” of economics textbooks is not really
a firm at all. e firm is treated as a production function or production
possibilities set, a “black box” that transforms inputs into outputs. While
descriptively vacuous, the production-function approach has the appeal
of analytical tractability along with its elegant parallel to neoclassical consumer
theory (profit maximization is like utility maximization, isoquants
are indifference curves, and so on). Nonetheless, many economists now
see it as increasingly unsatisfactory, as unable to account for a variety
of real-world business practices: vertical and lateral integration, mergers,
geographic and product-line diversification, franchising, long-term commercial
contracting, transfer pricing, research joint ventures, and many
others. e inadequacy of the traditional theory of the firm explains much
of the recent interest in agency theory, transaction cost economics, the capabilities
approach, and other facets of the “new institutional economics.” 1
A more serious problem with the traditional theory, however, has received
less attention. e theory of profit maximization is nearly always told from
the perspective of the manager, the agent who operates the plant, not that
of the owner, who supplies the capital to fund the plant. Yet owners control
how much authority to delegate to operational managers, so capitalists are
the ultimate decision makers. To understand the firm, then, we must focus
on the actions and plans of the suppliers of financial capital.
Focusing on capital markets and the corporate governance problem
highlights a fundamental analytical problem with the traditional approach
1 e new institutional economics is reviewed and critiqued in Furubotn and Richter
(1997), Klein (2000), Williamson (2000), Ménard and Shirley (2005) and Brousseau and
Glachant (2008).

25
to the theory of the firm. In the production-function approach, money
capital is treated as a factor of production. e manager’s objective is to
maximize the difference between total revenues and total costs, with the
cost of capital treated simply as another cost (and typically assumed to
be exogenous). e residual, “profit,” is retained by the manager. Hence
financial capital receives scant attention. As discussed below, this can be a
serious flaw.
Two Alternative Perspectives
What, then, is the proper way to understand the business firm? Two alternative
perspectives deserve consideration. e first perspective, which has
received substantial attention in the Austrian literature, is that of the entrepreneur,
or what Mises (1949, p. 256) calls the “entrepreneur-promoter.”
Entrepreneurship, in the Misesian sense, is the act of bearing uncertainty.
Production unfolds through time, and thus the entrepreneur must purchase
factors of production in the present (paying today’s prices, which are
known), in anticipation of revenues from the future sale of the product
(at tomorrow’s prices, which are uncertain). Entrepreneurial profit or loss
is the difference between these revenues and the initial outlays, less the
general rate of interest. As such, profit is the reward for successfully bearing
uncertainty. Successful promoters make accurate forecasts of future prices
and receive returns greater than their outlays. ose whose forecasts are
less accurate earn losses. Promoters who systematically make poor forecasts
quickly find themselves unable to secure any further resources for
investment and eventually exit the market. 2
e second perspective is that of the capitalist, the owner of the
firm. Ownership can also be thought of as a factor of production—what
Rothbard (1962, pp. 601–05) calls the “decision making factor”—but it is
2 Mises (1949, p. 254) defines the entrepreneurial function broadly, referring to “the aspect
of uncertainty inherent in every action.” He quotes the English idiom: “ere’s many
a slip ’twixt cup and lip” (p. 254). He defines entrepreneur-promoters more narrowly, as
uncertainty-bearers “who are especially eager to profit from adjusting production to the
expected changes in conditions, those who have more initiative, more venturesomeness,
and a quicker eye than the crowd, the pushing and promoting pioneers of economic
improvement.” He laments that the same word, “entrepreneurship,” has been used both
for the general concept of uncertainty-bearing and the narrower role of the bold, active,
creative, business person.

26
different from the other factors. In an ownership approach, money capital
is treated as a unique factor of production, the “controlling factor”; the
investor is both ultimate decision-maker and residual claimant. e firm’s
objective is to maximize the return on the owner’s investment. Because
the owner delegates certain functions to managers, a central focus of the
theory of the firm becomes the problem of corporate governance: how do
suppliers of capital structure their arrangements with managers in a way
that maximizes their returns?
is chapter argues that the most interesting problems in the theory
of the firm relate to the intersection between the entrepreneurial function
and the capitalist function. Indeed, as Mises argued, the driving
force behind the market economy is a particular type of entrepreneur,
the capitalist-entrepreneur, who risks his money capital in anticipation of
future, uncertain, returns. Moreover, as discussed below, the entrepreneur
is nearly always also a capitalist, and the capitalist is also an entrepreneur.
Economists now increasingly recognize the importance of the capitalist
in the direction of the firm’s affairs. In the introduction to his influential
book Strong Managers, Weak Owners, Mark Roe (1994, p. vii) makes the
point succinctly:
Economic theory once treated the firm as a collection of machinery,
technology, inventory, workers, and capital. Dump these inputs
into a black box, stir them up, and one got outputs of products
and profits. Today, theory sees the firm as more, as a management
structure. e firm succeeds if managers can successfully coordinate
the firm’s activities; it fails if managers cannot effectively
coordinate and match people and inputs to current technologies
and markets. At the very top of the firm are the relationships among
the firm’s shareholders, its directors, and its senior managers. If
those relationships are dysfunctional, the firm is more likely to
stumble.
As Roe suggests, the relationships between the firm’s owners (shareholders)
and its top managers are centrally important in determining firm performance.
3
3 For surveys of the literature on corporate governance see Gilson (1996); Shleifer and
Vishny (1997) and Zingales (1998).

27
The Contractual Approach
Both the entrepreneurial perspective and the ownership perspective can
be understood from within the “contractual” framework associated with
Coase (1937). In the Coasian framework, as developed and expanded by
Williamson (1975, 1985, 1996), Klein, et al. (1978), Grossman and Hart
(1986), Hart and Moore (1990), and others, the boundary of the firm is
determined by the tradeoff, at the margin, between the relative transaction
costs of external and internal exchange. In this sense, firm boundaries
depend not only on technology, but on organizational considerations; that
is, on the costs and benefits of various contracting alternatives.
Moreover, economic organization, both internal and external, imposes
costs because complex contracts are usually incomplete. e transactioncost
literature makes much of the distinction between complete and incomplete
contracts. A complete contract specifies a course of action, a
decision, or terms of trade contingent on every possible future state of affairs.
In textbook models of competitive general equilibrium, all contracts
are assumed to be complete. e future is not known with certainty, but
the probability distributions of all possible future events are known. 4 In an
important sense, the model is “timeless”: all relevant future contingencies
are considered in the ex ante contracting stage, so there are no decisions to
be made as the future unfolds.
e Coasian approach relaxes this assumption and holds that complete,
contingent contracts are not always feasible. In a world of “true”
(structural, rather than parametric) uncertainty, the future holds genuine
surprises (Foss, 1993a), and this limits the available contracting options. In
simple transactions—for instance, procurement of an off-the-shelf component—uncertainty
may be relatively unimportant, and spot-market contracting
works well. For more complex transactions, such as the purchase
and installation of specialized equipment, the underlying agreements
will typically be incomplete—the contract will provide remedies for only
some possible future contingencies. 5 One example is a relational contract,
4 What Knight (1921) would describe as “risk,” rather than “uncertainty.”
5 Williamson (1975, 1985, 1996) attributes contractual incompleteness to cognitive
limits or “bounded rationality,” following Simon’s (1961, p. xxiv) interpretation of human
action as “intendedly rational, but only limitedly so.” Other economists are more agnostic,
assuming only that some quantities or outcomes are unobservable (or not verifiable to third

28
an agreement that describes shared goals and a set of general principles
that govern the relationship (Goldberg, 1980). Another is implicit contract—an
agreement that while unstated, is presumably understood by
all sides. 6 Regardless, contractual incompleteness exposes the contracting
parties to certain risks. In particular, investment in relationship-specific
assets exposes agents to a potential “holdup” problem: if circumstances
change, their trading partners may try to expropriate the rents accruing
to the specific assets. Suppose an upstream supplier tailors its equipment
to service a particular customer. After the equipment is in place, the
customer may demand a lower price, knowing that the salvage value of the
specialized equipment is lower than the net payment it offers. Anticipating
this possibility, the supplier will be unwilling to install the custom machinery
without protection for such a contingency, even if the specialized
technology would make the relationship more profitable for both sides.
One way to safeguard rents accruing to specific assets is vertical (or
lateral) integration, where a merger eliminates any adversarial interests.
Less extreme options include long-term contracts (Joskow, 1985, 1987,
1988, 1990), partial ownership agreements (Pisano, Russo, and Teece,
1988; Pisano, 1990), or agreements for both parties to invest in offsetting
relationship-specific investments (Heide and John, 1988). Overall, parties
may employ several governance structures. e Coasian literature tries to
match the appropriate governance structure with the particular characteristics
of the transaction. 7
Building Blocks of an Austrian Theory of the Firm
Beginning with the basic Coasian or contractual framework, we can add
two elements as building blocks to an Austrian theory of the firm: entrepreneurship
and economic calculation. Entrepreneurship represents the
bearing of uncertainty. Economic calculation is the tool entrepreneurs use
to assess costs and expected future benefits. Consider each in turn.
parties, such as the courts), in which case contracts cannot be made contingent on these
variables or outcomes.
6 is is the sense in which Kreps (1990a) understands “corporate culture.”
7 As noted in chapter 1 above (pp. 18–21), some Austrians have questioned the Coasian,
contractual approach as an appropriate basis for an Austrian theory of the firm. I do
not share these concerns, however, seeing Coase’s framework as a general heuristic that
can accommodate various notions of the origins of internal and external transaction costs,
including those emphasized in the Austrian literature.

29
Entrepreneurship
Entrepreneurship, in the Misesian sense, is the act of bearing uncertainty.
In an ever-changing world, decisions must be made based on expectations
of future events. Because production takes time, resources must be invested
before the returns on those investments are realized. If the forecast of
future returns is inaccurate, the expected profits will turn out to be losses.
is is, of course, true not only of financial investors, but of all human
actors. If the future were known with certainty, man would not act, since
his action would not change the future. us, all purposeful human action
carries some risk that the means chosen will not bring about the desired
end. In this sense, all human actors are entrepreneurs.
Austrians tend to focus on this kind of pure entrepreneurship, the
entrepreneurial aspect of all human behavior. In doing so, however, they
often overlook a particular case of entrepreneurship, the driving force behind
the structure of production: the capitalist-entrepreneur, who risks his
money capital in anticipation of future events. Kirzner’s (1973; 1979) influential
interpretation of Mises identifies “alertness” or “discovery,” rather
than uncertainty bearing, as the defining property of entrepreneurship. In
Kirzner’s framework, entrepreneurial profit is the reward to superior alertness
to profit opportunities. e simplest case is that of the arbitrageur,
who discovers a discrepancy in present prices that can be exploited for
financial gain. In a more typical case, the entrepreneur is alert to a new
product or a superior production process and steps in to fill this market
gap before others.
Kirzner’s formulation has been criticized, however, for a lack of attention
to uncertainty. According to this criticism, mere alertness to a
profit opportunity is not sufficient for earning profits. To reap financial
gain, the entrepreneur must invest resources to realize the discovered profit
opportunity. “Entrepreneurial ideas without money are mere parlor games
until the money is obtained and committed to the projects” (Rothbard,
1985, p. 283). Moreover, excepting the few cases where buying low and
selling high are nearly instantaneous (say, electronic trading of currencies
or commodity futures), even arbitrage transactions require some time to
complete. e selling price may fall before the arbitrageur has made his
sale, and thus even the pure arbitrageur faces some probability of loss. In
Kirzner’s formulation, the worst that can happen to an entrepreneur is the

30
failure to discover an existing profit opportunity. Entrepreneurs either earn
profits or break even, but it is unclear how they suffer losses. 8
Mises, by contrast, consistently identifies entrepreneurship with both
profit and loss. “ere is a simple rule of thumb to tell entrepreneurs
from non-entrepreneurs. e entrepreneurs are those on whom the incidence
of losses on the capital employed falls” (Mises, 1951, p. 112). Moreover,
while Mises indeed acknowledges the element of entrepreneurship
in all human action, it is clear that the potential losses of the capitalistentrepreneurs
are particularly important:
Mises applies the concept of the entrepreneur to all cases of uncertainty-bearing,
and since laborers face uncertainty in deciding
where to move or what occupation to go into, laborers are also
entrepreneurs. But the most important case of entrepreneurship,
the driving force in shaping the actual structure and patterns of production
in the market economy, are the capitalist-entrepreneurs,
the ones who commit and risk their capital in deciding when, what,
and how much to produce. e capitalists, too, are far more subject
to actual monetary losses than are the laborers. (Rothbard, 1985,
p. 282) 9
Mises is careful to distinguish entrepreneurship from management,
the carrying out of those tasks specified by the capitalist-entrepreneur.
“[T]hose who confuse entrepreneurship and management close their eyes
to the economic problem” (Mises, 1949, p. 704). It is the capitalist-entrepreneurs
who control the allocation of capital to the various branches of
industry.
It is clear from this formulation that the capitalist-entrepreneur must
own property. He cannot invest without prior ownership of financial
capital. (1871, pp. 159–61) treatment of production includes as entrepreneurial
functions economic calculation, the “act of will,” and “supervision
of the execution of the production plan.” ese functions “entail property
ownership and, therefore, mark the Mengerian entrepreneur as a capitalistentrepreneur”
(Salerno, 1999a, p. 30). Menger describes “command of the
services of capital” as a “necessary prerequisite” for economic activity. Even
in large firms, although he may employ “several helpers,” the entrepreneur
himself continues to bear uncertainty, perform economic calculation, and
8 See chapter 5 below for further discussion of this point.
9 Of course, bondholders, as well as equity holders, are partly entrepreneurs, since even
bondholders bear some default risk.

31
supervise production, even if these functions “are ultimately confined . . .
to determining the allocation of portions of wealth to particular productive
purposes only by general categories, and to selection and control of
persons” (Menger, 1871, pp. 160–61; quoted in Salerno 1999a, p. 30). 10
An Austrian theory of the firm, then, is essentially a theory about the
ownership and use of capital. As Yu (1999, p. 7) puts it, “the Austrian
firm is a collection of capital resources.”
Unfortunately, the Austrian literature on the firm often confuses
entrepreneurship with innovation, strategic planning, leadership, and
other functions more properly associated with management than ownership.
Witt (1998), for example, describes entrepreneurship as a form
of “cognitive leadership.” Witt outlines a potential Austrian theory of the
firm by combining recent literature on cognitive psychology with Kirzner’s
concept of entrepreneurship. Entrepreneurs require complementary factors
of production, he argues, which are coordinated within the firm. For
the firm to be successful, the entrepreneur must establish a tacit, shared
framework of goals—what the management literature terms “leadership.”
A proper Austrian theory of the firm, then, must take account of the ways
in which entrepreneurs communicate their business conceptions within
the organization.
e problem with this argument is that while organizational leadership
is undoubtedly important, it is not particularly “entrepreneurial.”
Entrepreneurship has little necessarily to do with having a business plan,
communicating a “corporate culture,” or other dimensions of business
leadership; these are attributes of the successful manager, who may or
may not be an entrepreneur. 11 Moreover, even if top-level managerial
skill were the same as entrepreneurship, it is unclear why “cognitive leadership”—tacit
communication of shared modes of thought, core capabilities,
and the like—should be more entrepreneurial than other, comparatively
mundane managerial tasks such as structuring incentives, limiting opportunism,
administering rewards, and so on.
10 For more on Misesian entrepreneurship and its various interpretations, see chapter 5
below.
11 One distinction between entrepreneurship (as uncertainty bearing) and management
is that managerial functions can be purchased on the market: innovation can be outsourced
to R&D labs; strategic planning can be contracted out to consultants; corporate identities,
both internal and external, can be developed and communicated by outside specialists; and
so on.

32
Economic Calculation
All entrepreneurs, particularly capitalist-entrepreneurs, use economic calculation
as their primary decision-making tool. By economic calculation
we simply mean the use of present prices and anticipated future prices to
compare present costs with expected future benefits. In this way, the entrepreneur
decides what goods and services should be produced, and what
methods of production should be used to produce them. “e business
of the entrepreneur is not merely to experiment with new technological
methods, but to select from the multitude of technologically feasible methods
those which are best fit to supply the public in the cheapest way with
the things they are asking for most urgently” (Mises, 1951, p. 110). To
make this selection, the entrepreneur must be able to weigh the costs and
expected benefits of various courses of action.
As discussed in the previous chapter, the need for economic calculation
places ultimate limits on the size of the organization. Indeed, many writers
have recognized the connections between the socialist calculation debate
and the problems of internal organization (Montias, 1976; Williamson,
1991c). Kirzner, for example, interprets the costs of internal organization
in terms of Hayek’s knowledge problem:
In a free market, any advantages that may be derived from “central
planning” ... are purchased at the price of an enhanced knowledge
problem. We may expect firms to spontaneously expand to the
point where additional advantages of “central” planning are just
offset by the incremental knowledge difficulties that stem from dispersed
information. (Kirzner, 1992, p. 162)
What, precisely, drives this knowledge problem? e mainstream literature
on the firm focuses mostly on the costs of market exchange, and
much less on the costs of governing internal exchange. e new research
has yet to produce a fully satisfactory explanation of the limits to firm size
(Williamson, 1985, chap. 6). In Coase’s words, “Why does the entrepreneur
not organize one less transaction or one more?” Or, more generally,
“Why is not all production carried on in one big firm?” (Coase, 1937,
pp. 393–94). Existing contractual explanations rely on problems of authority
and responsibility (Arrow, 1974); incentive distortions caused by
residual ownership rights (Grossman and Hart, 1986; Hart and Moore,
1990; Hart, 1995); and the costs of attempting to reproduce market gov-

33
ernance features within the firm (Williamson, 1985, chap. 6). Rothbard
(1962, pp. 609–16) offered an explanation for the firm’s vertical boundaries
based on Mises’s claim that economic calculation under socialism is
impossible. Rothbard argued that the need for monetary calculation in
terms of actual prices not only explains the failures of central planning
under socialism, but places an upper bound on firm size.
Rothbard’s account begins with the recognition that Mises’s position
on socialist economic calculation is not exclusively, or even primarily,
about socialism, but about the role of prices for capital goods. Entrepreneurs
allocate resources based on their expectations about future prices,
and the information contained in present prices. To make profits, they
need information about all prices, not only the prices of consumer goods
but the prices of factors of production. Without markets for capital
goods, these goods can have no prices, and hence entrepreneurs cannot
make judgments about the relative scarcities of these factors. In any
environment, then—socialist or not—where a factor of production has
no market price, a potential user of that factor will be unable to make
rational decisions about its use. Stated this way, Mises’s claim is simply that
efficient resource allocation in a market economy requires well-functioning
asset markets. To have such markets, factors of production must be
privately owned.
Rothbard’s contribution, described more fully in chapter 1 above, was
to generalize Mises’s analysis of this problem under socialism to the context
of vertical integration and the size of the organization. Rothbard writes
in Man, Economy, and State that up to a point, the size of the firm is
determined by costs, as in the textbook model. However, “the ultimate
limits are set on the relative size of the firm by the necessity for markets to
exist in every factor, in order to make it possible for the firm to calculate
its profits and losses” (Rothbard, 1962, p. 599).
Consider, for example, a large, integrated firm organized into semiautonomous
profit centers, each specializing in a particular final or intermediate
product. e central management of the firm uses the implicit
incomes of the business units, as reflected in statements of divisional profit
and loss, to allocate physical and financial capital across the divisions.
To compute divisional profits and losses, the firm needs an economically
meaningful transfer price for all internally transferred goods and services. If
there is an external market for the component, the firm can use that market

34
price as the transfer price. Without a market price, however, the transfer
price must be estimated, either on a cost-plus basis or by bargaining between
the buying and selling divisions (Gabor, 1984; Eccles and White,
1988; King, 1994). Such estimated transfer prices contain less information
than actual market prices.
e use of internally traded intermediate goods for which no external
market reference is available thus introduces distortions that reduce
organizational efficiency. is gives us the element missing from contemporary
theories of economic organization, an upper bound: the firm is
constrained by the need for external markets for all internally traded goods.
In other words, no firm can become so large that it is both the unique
producer and user of an intermediate product; for then no market-based
transfer prices will be available, and the firm will be unable to calculate divisional
profit and loss and therefore unable to allocate resources correctly
between divisions. Of course, internal organization does avoid the holdup
problem, which the firm would face if there were a unique outside supplier;
conceivably, this benefit could outweigh the increase in “incalculability”
(Rothbard, 1962, p. 614). Usually, however, the costs from the loss of
calculation will likely exceed the costs of external governance. 12
Like Kirzner (1992), Rothbard viewed his contribution as consistent
with the basic Coasian framework, noting that his treatment of the limits
of the firm “serves to extend the notable analysis of Professor Coase on
the market determinants of the size of the firm, or the relative extent of
corporate planning within the firm as against the use of exchange and
the price mechanism. . . . e costs of internal corporate planning become
prohibitive as soon as markets for capital goods begin to disappear, so that
the free-market optimum will always stop well short not only of One Big
Firm throughout the world market but also of any disappearance of specific
markets and hence of economic calculation in that product or resource”
(Rothbard, 1976, p. 76). “Central planning” within the firm, then, is
12 Similarly, Rothbard’s claim is not that because external prices are necessary for large
firms to function efficiently, firms will tend to become large where external markets are
“thick” or better developed. On the contrary, large firms typically arise precisely where
external markets are poorly developed or hampered by government intervention; these are
the kinds of circumstances that give entrepreneurs an advantage in coordinating activities
internally (Chandler, 1977). However, such firms are still constrained by the need for some
external market reference.

35
possible only when the firm exists within a larger market setting.
Capital Markets
If the capitalist-entrepreneur is the driving force behind the industrialized,
market economy, then economists should focus their attention on the
financial markets, the capitalist-entrepreneur’s main venue. It is here that
this most important form of entrepreneurship takes place. Of course, in
the traditional, production-function theory of the firm, capital markets
do little but supply financial capital to managers, who can get as much
capital as they wish at the going market price. In a more sophisticated
understanding, managers do not decide how much capital they want; capitalists
decide where capital should be allocated. In doing so, they provide
essential discipline to the plant-level manager, whom Mises (1949, p. 301)
calls the entrepreneur’s “junior partner.”
When capitalists supply resources to firms, they usually delegate to
managers the day-to-day responsibility for use of those resources. Managers
may thus be able to use those resources to benefit themselves, rather
than the capitalist. e problem of managerial discretion—what we now
call the principal-agent problem—occupies much current research in the
theory of the firm. Under what conditions can managers exercise discretionary
behavior? What kinds of rules, or mechanisms, can be designed
to align the manager’s interest with the owner’s? Without effective rules,
what actions will managers choose? An early application was the proposed
“separation of ownership and control” in the modern corporation. Berle
and Means (1932) argued that the modern firm is run not by its owners,
the shareholders, but by salaried managers, whose interests are different
from those of shareholders and include executive perks, prestige, and similar
rewards. If the corporation is diffusely held, no individual shareholder
has sufficient motivation to engage in (costly) monitoring managerial decisions,
and therefore discretion will flourish at the expense of the market
value of the firm. However, Berle and Means did not consider how owners
might limit this discretion ex ante, without the need for detailed ex post
monitoring.
Agency theory—now the standard language of corporate finance—addresses
these problems. As developed by Jensen and Meckling (1976);
Fama (1980); Fama and Jensen (1983), and Jensen (1986), agency theory

36
studies the design of ex ante incentive-compatible mechanisms to reduce
agency costs in the face of potential moral hazard (malfeasance) by agents.
Agency costs are defined by Jensen and Meckling (1976, p. 308) as the
sum of “(1) the monitoring expenditures of the principal, (2) the bonding
expenditures by the agent, and (3) the residual loss.” e residual loss
represents the potential gains from trade that fail to be realized because
perfect incentives for agents cannot be provided when the agent’s actions
are unobservable. In a typical agency model, a principal assigns an agent to
do some task (producing output, for instance), but has only an imperfect
signal of the agent’s performance (for example, effort). e agency problem
is analogous to the signal-extraction problem popularized in macroeconomics
by Lucas (1972): how much of the observable outcome is due
to the agent’s effort, and how much is due to factors beyond the agent’s
control? e optimal incentive contract balances the principal’s desire to
provide incentives to increase the agent’s effort (for example, by basing
compensation on the outcome) with the agent’s desire to be insured from
the fluctuations in compensation that come from these random factors.
Owners of corporations (shareholders) use a variety of control or governance
mechanisms to limit the managerial discretion described by Berle
and Means. Both “internal” and “external” governance may be employed.
Internally, owners may establish a board of directors to oversee the actions
of managers. ey can use performance-based compensation to motivate
managers to act in the owners’ interest (for instance, giving managers
stock options instead of cash bonuses). ey can adopt a particular organizational
form, such as the “M-form” structure, in which managerial
discretion is more easily kept in check (Williamson, 1975). Finally, they
can rely on competition within the firm for top-level management positions—what
Fama (1980) calls the internal market for managers—to limit
the discretionary behavior of top-level management.
Even more important are external forces that help align managers’
interests with those of shareholders. Competition in the product market,
for example, assures that firms whose managers engage in too much discretionary
behavior will fail, costing the managers their jobs. In countries
where universal banking is permitted, large equity holders such as banks
can exercise considerable influence over managerial behavior. e external
governance mechanism that has received the most attention, however, is
the market for ownership itself, the “market for corporate control.”

37
Henry Manne’s essay, “Mergers and the Market for Corporate Control”
(1965), responded to Berle and Means by noting that managerial
discretion will be limited if there is an active market for control of corporations.
When managers engage in discretionary behavior, the share price
of the firm falls, and this invites takeover and subsequent replacement of
incumbent management. erefore, while managers may hold considerable
autonomy over the day-to-day operations of the firm, the stock market
places strict limits on their behavior.
e central insight of Manne’s paper is also found in Mises’s Human
Action (1949), in the passage distinguishing what Mises calls “profit management”
from “bureaucratic management” (pp. 300–07). It is true, Mises
acknowledges, that the salaried managers of a corporation hold considerable
autonomy over the day-to-day operations of the firm. Nonetheless,
the shareholders make the ultimate decisions about allocating resources to
the firm, in their decisions to buy and sell stock:
[e Berle–Means] doctrine disregards entirely the role that the
capital and money market, the stock and bond exchange, which
a pertinent idiom simply calls the “market,” plays in the direction
of corporate business.... [T]he changes in the prices of common
and preferred stock and of corporate bonds are the means applied
by the capitalists for the supreme control of the flow of capital.
e price structure as determined by the speculations on the capital
and money markets and on the big commodity exchanges not only
decides how much capital is available for the conduct of each corporation’s
business; it creates a state of affairs to which the managers
must adjust their operations in detail. (Mises, 1949, p. 303)
Mises does not identify the takeover mechanism per se as a means for
capitalists to exercise control—takeovers were much less popular before
the late 1950s, when the tender offer began to replace the proxy contest
as the acquisition method of choice—but the main point is clear: the true
basis of the market system is not the product market, the labor market,
or the managerial market, but the capital market, where entrepreneurial
judgments are exercised and decisions carried out.
Toward an Austrian Theory of Corporate Governance
Given that financial-market entrepreneurship is the defining feature of a
market economy, that economic calculation is the capitalist-entrepreneur’s

38
primary tool, and that economic calculation requires well-functioning
capital markets, what can capitalist-entrepreneurs do to govern their relationships
with operational managers? What should be the basis of
an Austrian theory of corporate governance? is section suggests four
areas that Austrians should address: (1) the concept of the firm as an
investment; (2) the relationship between internal and external capital
markets; (3) comparative corporate governance; and (4) financiers as
entrepreneurs. Consider each in turn.
Firms as Investments
Because the owner, and not the manager, is the ultimate decision-maker,
the Austrian theory of the firm should comprise two elements: a theory
of investment (corporate finance), and a theory of how investors provide
incentives for managers to use these resources efficiently (corporate governance).
In microeconomics textbooks, by contrast, what the capital
investors give to the firm is treated as just another factor of production. Its
price, the “rental price of capital” or interest, is simply another cost to the
producer. Any excess of revenues over costs, including the cost of capital,
goes to the manager (sometimes confusingly called the “entrepreneur”).
is residual is called “profit,” though it is not profit in the Misesian sense.
In the ownership perspective, as developed by Gabor and Pearce (1952,
1958), Vickers (1970, 1987), Moroney (1972), and others, the firm is
viewed as an investment. e firm’s goal is to maximize the return on
invested capital. is money capital may be regarded as a factor of production,
but it is a unique factor, the “controlling” factor that receives
the net proceeds of the operation. Other factors, such as labor (including
management) and physical capital, are regarded as “contracting” factors
that receive a fixed payment. e services of the top-level manager are thus
treated as a cost, while the investor is considered the residual claimant. Also
note that because the capitalist bears the risk that the investment will fail,
upon investing the capitalist has become an entrepreneur. Furthermore,
to the extent that the entrepreneur (as Kirznerian discoverer) hires himself
out to the capitalist as a salaried manager, his compensation is not entrepreneurial
profit; it is a cost to the owner of the firm (Rothbard, 1985,
p. 283). is has significant implications for firm behavior. First, the firm

39
will not always expand output to the point where marginal revenue equals
marginal cost. For if the firm is earning positive net returns at its current
level of output, instead of increasing output until marginal net returns
fall to zero, the firm could simply take those returns and employ them
elsewhere, either to set up a new firm in the same industry or to diversify
into a new industry (Gabor and Pearce, 1952, p. 253). e efficient scale of
production is determined by outside investment opportunities, not simply
the marginal returns from producing a single output.
Indeed, it is easy to show that under fairly weak assumptions, the
output level that maximizes the profit rate is less than the output level
that maximizes the level of profit. Consider a standard, concave profit
function; add a “money capital requirement,” the amount of capital required
to finance a given level of output. As long as the money capital
requirement is increasing in output, the output level that maximizes the
profit rate—profit divided by the money capital required to finance that
output level—is less than the output level that maximizes profit. From the
capitalist’s perspective, output should be expanded to the point where the
return on the last dollar of money capital is just equal to the opportunity
cost of that last dollar of money capital. But as long as the plant manager is
not free to invest his financial capital elsewhere, the manager’s cost curves
do not reflect this opportunity cost. Hence, the manager chooses a higher
output level than that which maximizes the capitalist’s return.
Significantly, for internal accounting purposes, firms are typically
structured such that the goal of any operating unit is to maximize the
return on its invested capital. In fact, not only do firms set up divisions as
profit centers, as discussed above, but groups of profit centers are frequently
grouped together as “investment centers” within the firm itself. Reece
and Cool (1978) studied 620 of the largest US firms in 1978 and found
that seventy-four percent had investment centers. ese subunits are
commonly evaluated according to a return on investment (ROI) criterion,
such as the ratio of accounting net income generated by the investment
center divided by total assets invested in the investment center. More
recently, measures such as residual income and “economic value added”
(EVA) have become popular as an alternative to ROI (Stern, Stewart, and
Chew, 1995). e point is that individual divisions are being evaluated
on the same basis as the corporation itself—namely, what kind of return

40
is being generated on the financial resources invested.
Second, the firm-as-investment concept relates closely to an emerging
literature on merger as a form of firm-level investment (Bittlingmayer,
1996; Andrade and Stafford, 2004). Once managers have acquired financial
resources from capitalists, these managers have some discretion
over how to invest those resources. To supplement the “normal” forms
of firm-level investment—capital expenditures and R&D—managers may
choose to purchase assets of existing firms through merger. Merger may
be a different form of investment; Andrade and Stafford (2004) find, for
example, that mergers in particular industries tend to be clustered over
time, while rankings of non-merger forms of investment by industry tend
to remain constant. is suggests that merger activity is encouraged by specific
industry or policy shocks, like deregulation, the emergence of junkbond
financing, and increased foreign competition (Mitchell and Mulherin,
1996). Nonetheless, mergers will be evaluated by the returns they
generate, just like any other investment.
Internal Capital Markets
In his extension of the Coasian framework, Williamson (1975, 1981)
describes the modern multidivisional or “M-form” corporation as a means
of intra-firm capital allocation. Capital markets allocate resources between
stand-alone, single-product firms. In the diversified, multidivisional
firm, by contrast, resources are allocated internally, as the entrepreneur
distributes funds among profit-center divisions. is “internal capital
market” replicates the allocative and disciplinary roles of the financial
markets, shifting resources toward more profitable lines of production. 13
Coase claimed that firms “supplant” markets when the transaction costs
13 Such a process is described explicitly in the 1977 Annual Report of Fuqua Industries,
a diversified firm with interests in lawn and garden equipment, sports and recreation,
entertainment, photofinishing, transportation, housing, and food and beverages:
Fuqua’s strategy is to allocate resources into business segments having
prospects of the highest return on investment and to extract resources from
areas where the future return on investment does not meet our ongoing
requirements.... e same principle of expanding areas of high return
and shrinking areas of low return is constantly extended to product lines
and markets within individual Fuqua operations. Only with a diversified
business structure is the application of this modern fundamental business
investment policy practical.

41
of market exchange exceed those of internal production. Williamson adds
that diversified, multidivisional firms “supplant” capital markets when the
costs of external finance exceed those of internal resource allocation.
According to the internal capital markets theory, diversified firms arise
when limits in the capital market permit internal management to allocate
and manage funds more efficiently than the external capital market. ese
efficiencies may come from several sources. First, the central headquarters
of the firm (HQ) typically has access to information unavailable to
external parties, which it extracts through its own internal auditing and
reporting procedures (Williamson, 1975, pp. 145–47). 14 Second, managers
inside the firm may also be more willing to reveal information to
HQ than to outsiders, since revealing the same information to the capital
market would also reveal it to rival firms, potentially hurting the firm’s
competitive position. ird, HQ can also intervene selectively, making
marginal changes to divisional operating procedures, whereas the external
market can discipline a division only by raising or lowering the share price
of the entire firm. Fourth, HQ has residual rights of control that providers
of outside finance do not have, making it easier to redeploy the assets
of poorly performing divisions (Gertner, Scharfstein, and Stein, 1994).
More generally, these control rights allow HQ to add value by engaging in
“winner picking” among competing projects when credit to the firm as a
whole is constrained (Stein, 1997). Fifth, the internal capital market may
react more “rationally” to new information: those who dispense the funds
need only take into account their own expectations about the returns to
a particular investment, and not their expectations about other investors’
expectations. Hence there would be no speculative bubbles or waves.
Bhidé (1990) uses the internal capital markets framework to explain
both the conglomerate merger wave of the 1960s and the divestitures of
the 1980s, regarding these developments as responses to changes in the
relative efficiencies of internal and external finance. For instance, corporate
refocusing can be explained as a consequence of the rise of takeover by
Another highly diversified firm, Bangor Punta Corporation, explains that the role of its
corporate headquarters is “to act as a central bank supplying operating units with working
capital and capital funds” (1966 Annual Report).
14 Myers and Majluf (1984) show that if the information asymmetry between a standalone
firm and potential outside investors is large enough, the firm may forego investments
with positive net present value rather than issue risky securities to finance them.

42
tender offer rather than proxy contest, the emergence of new financial techniques
and instruments like leveraged buyouts and high-yield bonds, and
the appearance of takeover and breakup specialists, like Kohlberg Kravis
Roberts, which themselves performed many functions of the conglomerate
HQ (Williamson, 1992). Furthermore, the emergence of the conglomerate
in the 1960s can itself be traced to the emergence of the M-form
corporation. Because the multidivisional structure treats business units
as semi-independent profit or investment centers, it is much easier for
an M-form corporation to expand via acquisition than it is for the older
unitary structure. New acquisitions can be integrated smoothly when they
can preserve much of their internal structure and retain control over dayto-day
operations. In this sense, the conglomerate could emerge only
after the multidivisional structure had been diffused widely throughout
the corporate sector.
Internal capital market advantages, then, explain why diversification
can increase the value of the firm. During the 1960s, entrepreneurs took
advantage of financial-market imperfections (many due to regulatory interference)
to form large, highly diversified firms (Hubbard and Palia, 1999;
Klein, 2001). ey also benefited from government spending in hightechnology
and other defense-related businesses, which were particularly
suited for acquisition. In the two subsequent decades, financial-market
performance improved, reducing the internal capital market advantages of
conglomerate firms.
If entrepreneurs have a special ability to manage information and allocate
financial resources within the firm—if diversified firms “supplant”
external capital markets—then why are capital markets necessary at all?
Why not, to paraphrase Coase’s (1937, pp. 393–94) second question, organize
the entire economy as one giant conglomerate? e answer is that
the argument for internal capital market advantages does not “scale up”; it
applies only to firms that are themselves engaged in rivalrous competition.
is situation, in turn, implies strict limits to firm size, even for large
conglomerates.
e argument for the efficiency of internal capital markets is that compared
with outside investors, the entrepreneur can extract additional information
about divisional requirements and performance. It is not that
the entrepreneur’s knowledge substitutes for the knowledge embodied in
market prices. To evaluate the merit of a proposed investment, the central

43
management of a diversified conglomerate still relies on market prices to
calculate expected (money) benefits and cost. Internal accounting does not
substitute for money prices; it merely uses the information contained in
prices in a particular way. When capital-goods prices are distorted—for
example, because of financial market regulation—then the entrepreneur’s
additional knowledge is that much more valuable. So under those conditions
we would expect an increase in M-form corporations, allocating
resources via internal capital markets. During the 1960s, that is exactly
what we observed.
Correctly understood, the internal capital markets hypothesis does not
state that internal capital markets supplant financial markets. It states
that internal capital markets supplement financial markets. Even ITT’s
Harold Geneen, LTV’s James Ling, Litton’s “Tex” ornton, and the other
conglomerators of the 1960s were constrained by the need for economic
calculation in terms of money prices. ornton’s “Whiz Kids” have been
criticized for their advocacy of “scientific management” or “management
by the numbers.” Yet ornton’s techniques were quite successful at Litton.
It was only when his disciple Robert McNamara tried to apply the same
techniques to a nonmarket setting—the Vietnam War—that the limitations
of “scientific management” were revealed. 15
Comparative Corporate Governance
How well do various systems of corporate governance function? e last
few years have seen the growth of a new literature on “comparative corporate
governance,” the study of alternative means of governing relations
between firm owners and managers. e typical comparison is between
stock-market systems like those in the US and UK, and bank-centered systems
like those in Germany and Japan (Roe, 1994; Gilson and Black, 1998;
Milhaupt, 1997). According to Roe, the phenomenon he calls “strong
managers, weak owners” is an outgrowth not of the market process, but of
legal restrictions on firm ownership and control. In the US, for example,
banks and other institutions are forbidden from owning firms; antitrust
laws prohibit industrial combinations like the Japanese keiretsu; and antitakeover
restrictions dilute the effects of the takeover mechanism. Laws
that require diffuse ownership create what Roe terms the “Berle–Means
15 For more on the relationship between ornton and McNamara, see Shapley (1993),
and Byrne (1993).

44
corporation,” in which “fragmented ownership shifts power in the firm to
managers” (p. 93).
Mises makes a very similar argument in Human Action. ere he
notes that “the emergence of an omnipotent managerial class is not a phenomenon
of the unhampered market economy,” but a result of government
policy (Mises, 1949, p. 304). Here he expands upon his earlier
analysis in Bureaucracy (1944, p. 12), where he attacks the claim that bureaucracy
follows naturally from firm size. Mises conceives of bureaucracy
as rule-following, as opposed to profit-seeking, behavior. He reserves the
term “bureaucratic management” for the governing of activities that have
no cash value on the market. As long as a firm’s inputs and outputs are
bought and sold, the central management of the firm will have the information
provided by market prices to evaluate the efficiency of the various
branches and divisions within the firm. en subordinate managers can
be given wide discretion to make daily operational decisions without the
pursuit of profit. 16 If an organization produces a good or service that has
no market price—the output of a government agency, for example—then
subordinate managers must be given specific instructions for how to perform
their tasks.
e fact that managers in a private firm have latitude to make dayto-day
decisions, Mises argues, does not make the firm “bureaucratic.”
“No profit-seeking enterprise, no matter how large, is liable to become
bureaucratic provided the hands of its management are not tied by government
interference. e trend toward bureaucratic rigidity is not inherent
in the evolution of business. It is an outcome of government meddling
with business” (Mises, 1944, p. 12). By this Mises means that government
interference impedes the entrepreneur’s use of economic calculation and
the attempt to use prices to impose managerial discipline. Mises gives three
examples (pp. 64–73): taxes and price regulations that interfere with corporate
profits (distorting an important signal of managerial performance);
16 Chapter 1 of Bureaucracy, on profit management and the sources of entrepreneurial
profit, contains a remarkably lucid account of economic calculation under capitalism and
its impossibility under socialism. “To the entrepreneur of capitalist society a factor of
production through its price sends out a warning: Don’t touch me, I am earmarked for
another, more urgent need. But under socialism these factors of production are mute”
(Mises, 1944, p. 29). Mises also provides a very Coase-like discussion of the make-or-buy
decision, though without citation (p. 33).

45
laws that interfere with hiring and promotion (including the need to hire
public relations staffs and legal and accounting personnel to comply with
government reporting requirements); and the omnipresent threat of arbitrary
antitrust or regulatory activity, in response to which entrepreneurs
must become adept at “diplomacy and bribery” (p. 72). Absent such legal
restrictions, Mises would argue, managerial autonomy is no inefficiency;
it’s an essential tool for operating a large, decentralized organization. But
the firm must have accurate divisional accounting statements to evaluate
managerial performance, and for this it needs the information contained
in market prices.
Financiers as Entrepreneurs
As mentioned above, much current research in the theory of the firm
focuses on the agency problem. Under what conditions can managers
exercise discretionary behavior? What kinds of rules, or mechanisms, can
be designed to align the manager’s interest with the owner’s? Without
effective rules, what actions will managers choose? Mises was well aware
of the agency problems, or conflicts of interest, that emerge in organizations
(e.g., Mises, 1944, pp. 42–47). But, as we have seen, he saw the
firm’s owner or owners as playing the primary entrepreneurial role, and
paid special attention to the mechanisms available to owners to limit this
discretion. Financiers, acting in stock and bond markets—writing today,
Mises would probably have discussed private-equity markets as well—are
the large firm’s ultimate decision-makers. Rothbard (1962, p. 602) puts it
this way:
Hired managers may successfully direct production or choose production
processes. But the ultimate responsibility and control of
production rests inevitably with the owner, with the businessman
whose property the product is until it is sold. It is the owners who
make the decision concerning how much capital to invest and in
what particular processes. And particularly, it is the owners who
must choose the managers. e ultimate decisions concerning the
use of their property and the choice of the men to manage it must
therefore be made by the owners and by no one else.
Kirzner (1973, p. 68) makes a similar point about alertness: it can never
be fully delegated. “It is true that ‘alertness’ . . . may be hired; but one

46
who hires an employee alert to possibilities of discovering knowledge has
himself displayed alertness of a still higher order. . . . e entrepreneurial
decision to hire is thus the ultimate hiring decision, responsible in the last
resort for all factors that are directly or indirectly hired for his project.”
Kirzner goes on to quote Knight (1921, p. 291): “What we call ‘control’
consists mainly of selecting someone else to do the ‘controlling.’ ”
Significantly, Mises’s treatment of the importance of financial markets
is key to his final rebuttal in Human Action to Lange, Lerner, and the
other market-socialist critics of his calculation argument (Mises, 1949,
pp. 694–711). e market socialists, he argued, fail to understand that the
main task performed by a market system is not the pricing of consumer
goods, but the allocation of capital among various branches of industry.
By focusing on production and pricing decisions within a given structure
of capital, the socialists ignore the vital role of capital markets. Rothbard
(1993) notes that the same criticism can be applied to the textbook,
production-function model of the firm, where capital is also taken for
granted. “Neoclassical microtheory talks about ‘managers’ producing up
to the point where MR = MC, without ever talking about who or what
is allocating capital to them. In short, neoclassical firms are implicitly assumed
to have a fixed amount of capital allocated to them . . . and they can
only use that capital to invest in their own firm and nowhere else. Hence,
the nonsensical conclusion that each firm’s manager will try to squeeze out
the last cent of profit, pushing production until MR = MC.” Fortunately,
the new literature on transaction-cost determinants of contractual relations
has begun to bring capital back into the received microtheory.
Failure to understand the entrepreneurial role of capital providers
plagues the mainstream literature in corporate finance and corporate
control. For example, there is considerable debate about the effectiveness
of the takeover mechanism in providing managerial discipline. If managers
desire acquisitions to increase their own prestige or span of control—to
engage in “empire building”—then an unregulated market will generate
too many takeovers. Merger critics such as Ravenscraft and Scherer (1987),
discussed in chapter 3 below, support increased restrictions on takeover
activity. Jensen (1986, 1993) suggests changes in the tax code to favor
dividends and share repurchases over direct reinvestment, thus limiting
managers’ ability to channel free cash flow into unproductive acquisitions.

47
However, the fact that some mergers—indeed, many mergers, takeovers,
and reorganizations—turn out to be unprofitable does not imply
market failure or necessarily prescribe any policy response. Errors will
always be made in a world of uncertainty. Even the financial markets,
which aggregate the collective wisdom of the capitalist-entrepreneurs, will
sometimes make the wrong judgment on a particular business transaction.
Sometimes the market will reward, ex ante, a proposed restructuring that
has no efficiency rationale. But this is due not to capital market failure,
but to imperfect knowledge. Final judgments about success and failure
can be made only ex post, as the market process plays itself out. Moreover,
there is no reason to believe that courts or regulatory authorities can make
better judgments than the financial markets. e decisions of courts and
government agencies will, in fact, tend to be far worse: unlike market
participants, judges and bureaucrats pursue a variety of private agendas,
unrelated to economic efficiency. Furthermore, the market is quick to
penalize error as it is discovered; no hearings, committees, or fact-finding
commissions are required. In short, that firms often fail is surprising only
to those committed to textbook models of competition in which the very
notion of “failure” is defined away.
Another criticism of the market for corporate control is that unregulated
financial markets engage in too few takeovers, due to a free-rider
problem associated with tender offers (see, for example, Scharfstein 1988).
Critics point out that if the difference between the current (undervalued)
price of the firm and its after-takeover market value is common knowledge,
then the target firm’s shareholders will refuse to tender their shares until
the current price is bid up, appropriating a share of the returns to the
acquiring firm. ese critics conclude that regulation, not the takeover
market, should be used to discipline managers.
e flaw in this argument is that it assumes perfect knowledge on
the part of investors. e typical shareholder will not usually have the
same information as incumbent managers, outside “raiders,” and other
specialists. It is not in the small shareholder’s interest to learn these details;
that is why he delegates such responsibilities to the managers in the first
place. As Hayek (1945) described it, there is a “division of knowledge” in
society. e raider who perceives and exploits a difference between a firm’s
current market value and its potential value under new management has
an opportunity for an entrepreneurial profit (less the transaction costs of

48
takeover). Because shareholders have delegated these responsibilities, they
will not usually earn a share of this profit. Nonetheless, as explained above,
because shareholders (owners) choose to delegate operational responsibility
to managers—contracting out for the managerial function—they themselves
retain the ultimate rights of control.
Moreover, the post-takeover market value of the firm is uncertain; the
raider’s profit, if he is successful, is the reward for bearing this uncertainty.
In this sense, the takeover artist is a Misesian capitalist-entrepreneur. is
account, however, could use further elaboration. For example, how is the
bearing of uncertainty distributed among participants in various forms of
restructuring? How do regulatory barriers hamper the capitalist-entrepreneur’s
ability to exercise the entrepreneurial function in this context?
Conclusions
e main message of this chapter is that Austrians can continue to work
within the contractual, or Coasian, approach to the firm in elaborating
the insights discussed above. In particular, the problem of corporate governance,
and the corollary view that firms are investments, belongs at the
forefront of Austrian research on the theory of the firm. Emphasis should
thus be placed on the plans and actions of the capitalist-entrepreneur.
A particularly undeveloped area concerns the provision of capital to
small, “entrepreneurial” ventures. Most of the literature on governance
focuses on the large corporation, and the use of stock and bond markets
to govern these organizations. Equally important, however, are smaller,
privately held firms, financed with venture capital or other forms of investment.
So far, the firm-as-investment literature has said little about
these organizations, despite their growing importance, particularly in highgrowth,
technologically-advanced industries like software and biotechnology.
Further research in this area is sorely needed.

CHAPTER 3
Do Entrepreneurs Make Predictable Mistakes?
Evidence From Corporate Divestitures †
With Sandra K. Klein
After a brief lull in the early 1990s, the market for corporate control became
increasingly active toward the end of the decade. Both 1996 and
1997 set new records for the number of US merger filings, and 1998,
1999, and 2000 brought high-profile “mega-mergers” in financial services,
energy, telecommunications, pharmaceuticals, and automobiles. In banking
alone, for example, a wave of mergers over the last decade has led to
widespread industry restructuring and consolidation. While total industry
activity continues to expand, the number of US banks and banking organizations
both fell by almost 30 percent between 1988 and 1997 (Berger,
Demsetz, and Strahan, 1999).
Like other business practices that do not conform to textbook models
of competition, mergers, acquisitions, and financial restructurings have
long been viewed with suspicion by some commentators and regulatory
† Published originally in Quarterly Journal of Austrian Economics 4, no. 2 (Summer
2001): 3–25. Reprinted in Nicolai J. Foss and Peter G. Klein, eds., Entrepreneurship and
the Firm: Austrian Perspectives on Economic Organization (Aldershot, UK: Edward Elgar,
2002).
49

50
authorities. However, the academic literature clearly suggests that corporate
restructurings do, on average, create value. Event studies of acquisitions
consistently find positive average combined returns to acquirer
and target shareholders. As summarized by Jensen (1991, p. 15), “the
most careful academic research strongly suggests that takeovers—along
with leveraged restructurings prompted by the threat of takeover—have
generated large gains for shareholders and for the economy as a whole.”
ese gains, historically about 8 percent of the combined value of the
merging companies, “represent gains to economic efficiency, not redistribution
between various parties” (Jensen, 1991, p. 23). 1
At the same time, however, several studies have found a sharp divergence
between market participants’ pre-merger expectations about the
post-merger performance of merging firms and the firms’ actual performance
rates. Ravenscraft and Scherer’s (1987) large-scale study of manufacturing
firms, for example, found that while the share prices of merging
firms did on average rise with the announcement of the proposed restructuring,
post-merger profit rates were unimpressive. Indeed, they find
that nearly one-third of all acquisitions during the 1960s and 1970s were
eventually divested. Ravenscraft and Scherer conclude that acquisitions,
particularly diversifying acquisitions, typically promote managerial “empire
building” rather than efficiency. While acknowledging that product
and capital markets eventually discipline poorly performing firms, forcing
divestitures and other restructurings, Ravenscraft and Scherer (p. 217)
argue for tighter government restrictions on mergers, particularly diversifying
acquisitions and acquisitions financed by stock: “When the roads are
strewn with wrecks, government officials cannot rest content because the
tow trucks, ambulances, and hearses are doing a good job removing the
remnants and clearing the right-of-way.” 2
Implicit in this criticism is the idea that divestitures of previously ac-
1 On the gains from mergers, acquisitions, and other restructurings, see also the surveys
by Jensen and Ruback (1983), Jarrell, Brickley, and Netter (1988), Roll (1988), Romano
(1992), and Andrade, Mitchell, and Stafford (2001).
2 Jensen (1986, 1993) argues similarly that diversifying acquisitions resulted from widespread
agency problems in corporations, though he does not recommend any regulatory
response: “e legal/political/regulatory system is far too blunt an instrument to handle the
problems of wasteful managerial behavior effectively” (1993, p. 850). Instead, he advocates
alternative forms of organization such as leveraged buyout associations and venture capital
funds (see especially Jensen, 1989).

51
quired assets expose past errors, and that these errors should have been
foreseen (and perhaps prevented, if regulators had been sufficiently empowered).
Certain types of acquisitions, it is claimed, are more likely to be
later divested, so managers should generally avoid them. If such acquisitions
occur, this is then cited as evidence for widespread agency problems.
In this sense, the takeover wave of the 1980s is typically understood as
an “undoing” of the earlier, conglomerate merger wave of the 1960s and
early 1970s. According to conventional wisdom, the 1980s was a period
of respecialization or “refocus,” showing the failures of unrelated diversification.
e three decades from 1960 to 1990 thus represent a “round trip
of the American corporation” (Shleifer and Vishny, 1991, p. 54).
is view is based partly on evidence from studies of the conglomerate
period by Rumelt (1974, 1982), Ravenscraft and Scherer (1987,
1991), Porter (1987), Kaplan and Weisbach (1992), and others who find
no evidence that unrelated diversification brought long-term benefits to
the firms that diversified. 3 Combined with evidence of negative stockmarket
returns to diversification during the 1980s (Bhagat, Shleifer, and
Vishny, 1990; Lang and Stulz, 1994; Berger and Ofek, 1995; Comment
and Jarrell, 1995), many observers conclude that unrelated diversification
is per se inefficient, and that the conglomerate era is best understood as an
agency phenomenon.
e conventional wisdom on conglomerate sell-offs can be challenged
on at least four grounds. First, divestitures of previously acquired assets
do not necessarily show that the original acquisitions were failures. Weston
(1989) argues that divestitures occur for a variety of reasons, such as
changes in corporate strategies and antitrust rules, and not necessarily poor
performance. Kaplan and Weisbach (1992) studied 217 large acquisitions
completed between 1971 and 1982 and found that while 43.9 percent
had been divested by 1989, only about a third of those divestitures were
responses to poor post-merger performance. 4 us the mere fact that
3 Servaes (1996) also finds that conglomerate firms in the 1960s were valued at a
discount relative to specialized firms. However, Matsusaka (1993) and Hubbard and
Palia (1999) show that market participants rewarded conglomerate acquisitions during
this period, and Klein (2001) offers valuation evidence consistent with the event-study
results.
4 Other empirical studies of asset sales and restructurings include Hite, Owens, and
Rogers (1987); Lang, Poulsen, and Stulz (1994); John and Ofek (1995); and Schlingemann,
Stulz, and Walkling (2002). ese papers look at divestitures more generally, and
not only at divestitures of previously acquired assets.

52
many acquisitions are later divested does not prove widespread managerial
misconduct.
Second, the market for corporate control is already highly regulated,
and it is difficult to draw from current and recent experience strong conclusions
about how unhampered capital markets would work. For example,
Ravenscraft and Scherer (1987, 1991), Porter (1987), and other critics
propose particular sequences of inefficient and efficient restructurings: diversifying,
empire-building acquisitions in the 1960s and early 1970s, and
then efficient divestitures in the 1980s. But why did entrepreneurs make
systematic mistakes during the conglomerate period, but not later? Can
changes in the legal, political, and regulatory environments account for
clusters of errors during specific periods?
ird, even if divestitures are seen as revealing prior mistakes, the
failure of a particular acquisition does not necessarily indicate a failure of
the acquisition strategy. Certain kinds of acquisitions—for example, acquisitions
of firms in knowledge-intensive, high-technology industries—may
be inherently riskier than others. If the returns from a successful integration
of the target’s activities with the firm’s existing activities are sufficiently
high, then the acquisition has positive expected value, even if it is more
likely to fail than a safer acquisition. Matsusaka (2001) offers this kind
of interpretation of corporate diversification. Diversifying acquisitions
represent experiments, as firms try various combinations of businesses,
seeking those that match their capabilities (in the sense of Penrose, 1959;
Nelson and Winter, 1982; and Wernerfelt, 1984). After learning their
capabilities, firms divest acquisitions that turn out to be poor matches.
In this sense, divestitures reflect successful experiments—the acquirer has
learned that the target’s industry is not a good match for its capabilities.
Such “match-seeking” firms will actively acquire and divest over time. 5
5 Sanchez, Heene, and omas (1996, p. 28) suggest that the same is true for networks
and alliances.
In a dynamic market context, longevity of interfirm alliances is not necessarily
an indicator of successful collaboration. A succession of short-term
alliances by a firm, for example, may suggest that the firm has a superior
ability to learn from its partners, or that it may have superior ability to
quickly reconfigure its chain of firm-addressable resources in response to
changing competitive and market conditions.
Mosakowski (1997) also offers an experimentation theory of diversification (without looking
at subsequent divestitures).

53
is chapter elaborates a fourth, “Austrian” interpretation of corporate
divestitures, one that builds on the three just mentioned. Austrian
writers view market competition as a dynamic, rivalrous process that unfolds
gradually through time—a “discovery procedure,” in Hayek’s (1978)
famous phrase. e future holds genuine surprises, not merely a closed
set of events whose probabilities are unknown. From this perspective,
the long-term success of an acquisition, like any entrepreneurial action,
cannot be “predicted.” Entrepreneurs rely on judgment, or what Mises
(1949) calls understanding. Understanding is intuitive, subjective, and
qualitative, and thus inherently imperfect. For this reason, divestitures of
underperforming subunits may be seen as efficient responses to unforeseen
changes in industry and regulatory conditions, or more generally, to poor
judgments by profit-seeking entrepreneurs. Ex post viability is not a good
indicator of ex ante efficiency.
We begin with the theory of entrepreneurship proposed by Mises
(1949), posing it as a challenge to the agency view of divestitures. We
then present empirical evidence that the long-term performance of corporate
acquisitions cannot, in general, be predicted by measures of agency
conflicts. Instead, divestitures of previously acquired assets are more likely
when firms are experimenting, learning, and otherwise trying to deal
with uncertainty about future conditions. We also show that mistaken
acquisitions are more likely under certain circumstances, namely during
periods of intense, industry-specific regulatory activity. Our own research
on restructuring (Klein and Klein, 2008) shows that significantly higher
rates of divestiture follow mergers that occur in a cluster of mergers in the
same industry. As argued by Mitchell and Mulherin (1996), Andrade,
et al. (2001), and Andrade and Stafford (2004), mergers frequently occur
in industry clusters, suggesting that mergers are driven in part by industryspecific
factors, such as regulatory shocks. When an industry is regulated,
deregulated, or re-regulated, economic calculation becomes more difficult,
and entrepreneurial activity is hampered. It should not be surprising that
poor long-term performance is more likely under those conditions.
is last result is consistent with the view, expressed repeatedly in the
Austrian literature, that entrepreneurial error is associated with government
intervention in the marketplace—in particular, with government ownership
of property and interference with the price system. Mises (1920)
famously showed that economic calculation is not possible without private

54
property in all markets, especially markets for factors of production. e
Austrian business-cycle literature (Mises, 1912; Hayek, 1935; Garrison,
2000) suggests that entrepreneurial errors are more likely under government-sponsored
credit expansion. is chapter makes a related argument:
entrepreneurial decisions to make acquisitions that will later be regretted,
and divested, are more likely in the wake of government intervention in
particular industries.
e remainder of the chapter is organized as follows. e first section
reviews the Austrian literature on entrepreneurship, uncertainty, and
economic calculation, suggesting that the ex post success of entrepreneurial
actions cannot be forecasted based on generally available information.
e second section introduces recent theory and evidence on the reasons
for mergers and divestitures, contrasting two opposing views of sell-offs:
empire-building and experimentation. e third section reviews some
empirical evidence on the pre-merger causes of divestiture, challenging
the generally accepted, empire-building explanation. e final section
concludes.
Entrepreneurship, Profit, and Loss
As discussed in chapter 2 above, Misesian entrepreneurship is a fundamentally
dynamic phenomenon, unfolding in calendar time. Entrepreneurial
profit or loss is the difference between eventual, uncertain revenues
and initial outlays, less the general rate of interest. Of course, Mises’s
entrepreneur-promoter is absent from textbook models of competitive
general equilibrium in which uncertainty is defined away, replaced by
probabilistic risk. In these models, it is possible to anticipate which actions,
on average, would be profitable. In a world of “true” (structural, rather
than parametric) uncertainty, however, profit opportunities do not exist
“out there,” waiting to be realized by anyone willing to take a specified
action. Instead, profit opportunities are created through entrepreneurial
action. As I read Mises, entrepreneurial skill is not simply luck or “alertness,”
the ability to recognize profit opportunities that appear, ex nihilo,
to the discoverer. Rather, entrepreneurship is judgment: “Alertness is the
mental quality of being on the lookout for something new; judgment is
the mental process of assigning relevance to those things we already know”

55
(High, 1982, p. 167). In this context,
promoter-entrepreneurs are those who seek to profit by actively
promoting adjustment to change. ey are not content to passively
adjust their ... activities to readily foreseeable changes or
changes that have already occurred in their circumstances; rather,
they regard change itself as an opportunity to meliorate their own
conditions and aggressively attempt to anticipate and exploit it.
(Salerno, 1993, p. 123; see also Hülsmann, 1997)
All entrepreneurs, particularly those who operate in financial markets,
use economic calculation as their primary decision-making tool. 6 By
economic calculation, Mises means simply the use of present prices and
anticipated future prices to compare present costs with expected future
benefits. In this way the entrepreneur decides what goods and services
should be produced, and what methods of production should be used
to produce them. “e business of the entrepreneur is not merely to
experiment with new technological methods, but to select from the multitude
of technologically feasible methods those which are best fit to supply
the public in the cheapest way with the things they are asking for most
urgently” (Mises, 1951, p. 110). To make this selection, the entrepreneur
must weigh the costs and expected benefits of various courses of action,
and for this he needs the cardinal numbers provided by money prices.
Monetary calculation, then, requires private property and market prices.
As we saw in chapter 1, Mises’s famous 1920 essay on economic
calculation under socialism is not so much about socialism per se; it is
an argument about the role of prices for capital goods (Rothbard, 1993,
pp. 547–78). Entrepreneurs make decisions about resource allocation
based on their expectations about future prices and the information contained
in present prices. To make profits, they need information about
all prices, not only the prices of consumer goods but the prices of factors
of production. Without markets for capital goods, these goods can have
no prices, and therefore entrepreneurs cannot make judgments about the
relative scarcities of these factors. In short, resources cannot be allocated
efficiently. In any environment, then—socialist or not—where a factor
6 Chapter 2 above argues that financial-market entrepreneurship is a particularly important
form of entrepreneurial activity, though it has received little attention in the Austrian
literature.

56
of production has no market price, a potential user of that factor will be
unable to make rational decisions about its use. Stated this way, Mises’s
claim is simply that efficient resource allocation in a market economy
requires well-functioning asset markets.
Despite Mises’s explicit focus on entrepreneurship, much of modern
production theory—indeed, the entire neoclassical theory of the firm—
focuses not on entrepreneurs, but managers. e traditional theory of
profit maximization is nearly always told from the perspective of the manager,
the agent who operates the plant, not that of the owner, who supplies
the capital to fund the plant. Yet owners control how much authority to
delegate to operational managers, so capitalists are, in an important sense,
the ultimate decision-makers. To understand the firm, then, we must focus
on the actions and plans of the suppliers of financial capital, the capitalistentrepreneurs.
It is true, of course, that when capitalist-entrepreneurs supply resources
to firms, they usually delegate to managers the day-to-day responsibility for
use of those resources. e resulting possibility for managerial discretion is
of course the focal problem of the modern literature on corporate finance
and the theory of the firm. As discussed in chapter 2 above, the literature
on corporate governance identifies a variety of mechanisms by which
shareholders can limit this discretion, such as establishing boards of directors,
using performance-based pay, adopting the “M-form” structure, and
exploiting competition among managers and potential managers. Outside
the firm, competition in product, labor, and capital markets helps align
managers’ interests with those of shareholders. 7
We should therefore be cautious in attributing the eventual divestiture
of many acquisitions, particularly during the 1960s and 1970s, to managerial
motives. Moreover, the claim that the acquisitive conglomerates of
the 1960s and 1970s were inefficient is inconsistent with recent evidence
that during those years, diversifying acquisitions—particularly those that
created internal capital markets—tended to increase the market values of
the acquiring firms (Matsusaka, 1993; Hubbard and Palia, 1999; Klein,
2001). In light of this evidence, “[t]he simple view that the 1980s ‘bustups’
were a corrective to past managerial excesses is untenable” (Matsusaka,
7 Jensen (1993) argues that internal control mechanisms are generally weak and ineffective,
while external control mechanisms—where allowed to function—are typically
superior.

57
1993, p. 376). In short, both theory and empirical evidence cast doubt
on the conventional wisdom that corporate managers made systematic,
predictable mistakes by acquiring (often unrelated) subunits during the
1960s and 1970s, and that financial-market participants made systematic
mistakes by approving these acquisitions.
Mergers, Sell-offs, and Efficiency: Theory and Evidence
Why, in general, do firms expand and diversify through merger? Why
do they sometimes retreat and “refocus” through divestiture? e theory
of merger is a subset of the theory of the optimal size and shape of the
firm, a relatively undeveloped area in the Austrian literature. Chapters 1
and 2 above argue for a modified Coasian, or contractual, view of firm
boundaries, in which the limits to organization are given by the need to
perform economic calculation using prices generated in external markets.
Other writers see the Austrian approach as more congenial to the resourcebased
theory of the firm, defining firms’ capabilities in terms of Hayekian
tacit knowledge (Langlois, 1992, 1994a; Minkler, 1993a). In either case,
we can think of merger or takeover as a response to a valuation discrepancy:
acquisition occurs when the value of an existing firm’s assets is greater to
an outside party than to its current owners. Put differently, a merger can
be a response to economies of scope, in that the value of the merging firms’
assets combined exceeds their joint values separately. 8 As with any voluntary
exchange, the transaction is (ex ante) advantageous to both parties,
and should thus be welfare-enhancing.
New combinations of corporate assets can generate efficiencies by
replacing poorly performing managers (Jensen and Ruback, 1983; Mitchell
8 Two popular explanations for multiproduct economies of scope center on internal
capital markets and strategic resources. According to the internal-capital-markets hypothesis,
as expressed by Alchian (1969), Williamson (1975), Gertner, et al. (1994), and Stein
(1997), internal capital markets have advantages where access to external funds is limited.
e central office of the diversified firm can use informational advantages, residual control
rights, and its ability to intervene selectively in divisional affairs to allocate resources within
the firm better than the external capital markets would do if the divisions were standalone
firms. In the resource-based view, the firm is regarded as a stock of knowledge,
establishing a range of competence that may extend across multiple product lines. Excess
profits or supranormal returns are seen as rents accruing to unique factors of production
(Montgomery and Wernerfelt, 1988) and firms diversify because they have excess capacity
in these unique factors.

58
and Lehn, 1990), creating operating synergies (Weston, Chung, and Hoag,
1990, pp. 194–95), or establishing internal capital markets (Alchian,
1969; Williamson, 1975; Gertner, et al., 1994; Stein, 1997). In particular,
considerable evidence suggests that the market for corporate control
disciplines incumbent management. For example, Morck, Shleifer, and
Vishny (1988) found that firms with lower Tobin’s q-ratios are more likely
to be targets of takeovers. Tobin’s q measures the ratio of the firm’s market
value to the replacement cost (or book value) of its assets. Because firms
with low market-to-book ratios have low expected cash flows relative to the
amount of invested capital, the market-to-book ratio can be interpreted as
a measure of the firm’s investment opportunities (Smith and Watts, 1992;
Gaver and Gaver, 1993), or as a measure of managerial inefficiency or
agency conflict within the firm (Lang, Stulz, and Walkling, 1991). Low-q
firms are the most likely takeover targets.
Given the benefits of takeovers, why are many mergers later “reversed”
in a divestiture or spin-off? Here we distinguish between two basic views.
e first, which may be termed empire-building, holds that entrenched
managers make acquisitions, often paying with the acquiring firm’s (inflated)
stock, primarily to increase their own power, prestige or control.
ese acquisitions produce negligible efficiency gains, and are thus more
likely to be divested ex post. Most important, because the acquiring firm’s
motives are suspect, such acquisitions are ex ante inefficient; neutral observers
can predict, based on pre-merger characteristics, that these mergers
are unlikely to be viable over time. By permitting these acquisitions,
capital-market participants are also guilty of systematic error. Admittedly,
in the empire-building view, markets did eventually correct these mistakes
with the restructurings of the 1980s. 9 Still, farsighted regulators could
have reduced social costs by limiting such acquisitions in the first place.
A second view, which we term entrepreneurial market process, acknowledges
that unprofitable acquisitions may be mistakes ex post, but argues
9 is raises the question of why, if managers were sufficiently entrenched to make
inefficient acquisitions in the first place, would they not remain sufficiently entrenched
to hold on to poorly performing targets, rather than divest them and risk revealing their
underlying objectives? Boot (1992, p. 1402) argues that an entrenched manager will not
divest because the external market will take divestiture as an admission of failure and a bad
signal of his ability. e argument that divestitures indicate agency problems thus assumes
a change in corporate control between the original acquisitions and the later divestitures.

59
that poor long-term performance does not indicate ex ante inefficiency. In
the market-process perspective, a divestiture of previously acquired assets
may mean simply that profit-seeking entrepreneurs have updated their
forecasts of future conditions or otherwise learned from experience. As
Mises (1949, p. 582) puts it, “the outcome of action is always uncertain.
Action is always speculation.” Consequently, “the real entrepreneur is a
speculator, a man eager to utilize his opinion about the future structure of
the market for business operations promising profits. is specific anticipative
understanding of the conditions of the uncertain future defies any
rules and systematization” (Mises, 1949, p. 582, emphasis in original). 10
As discussed above, this notion of entrepreneurial decision making
under uncertainty squares with recent theories of acquisitions as a form of
experimentation (Mosakowski, 1997; Boot, Milbourn, and akor, 1999;
Matsusaka, 2001). In these models, profit-seeking entrepreneurs can learn
their own capabilities only by trying various combinations of activities,
which could include diversifying into new industries. Firms may thus
make diversifying acquisitions even if they know these acquisitions are
likely to be reversed in a divestiture. is process generates information
that is useful for revising entrepreneurial plans, and thus an acquisition
strategy may be successful even if individual acquisitions are not. In these
cases, the long-term viability of an acquisition may be systematically related
to publicly observable, pre-merger characteristics associated with experimentation,
but not characteristics associated with managerial discretion.
To explain the particular pattern of mergers and acquisitions observed
over the last several decades, market-process explanations must appeal to
changes in the legal, political, competitive, or regulatory environments that
affect the ability of entrepreneurs to anticipate future conditions. Why,
for instance, was it particularly difficult for entrepreneurs to forecast the
success of acquisitions in the 1960s and 1970s? Why did entrepreneurs
feel a greater need to experiment with various combinations of businesses
during those years?
One possibility is that complex organizations with active internal capital
markets were necessary in the 1960s, but became less important after
capital markets were deregulated in the 1970s. e investment community
10 See chapter 6 below for details on Mises’s approach to uncertainty.

60
in the 1960s has been described as a small, close-knit group where competition
was minimal and peer influence strong Bernstein (1992). As Bhidé
(1990, p. 76) puts it, “internal capital markets . .. may well have possessed
a significant edge because the external markets were not highly developed.
In those days, one’s success on Wall Street reportedly depended far more
on personal connections than analytical prowess.” During that period, the
financial markets were relatively poor sources of capital. In 1975, the
SEC deregulated brokerage houses and removed its rule on fixed-price
commissions. e effect of deregulation, not surprisingly, was to increase
competition among providers of investment services. “is competitive
process has resulted in a significant increase in the ability of our external
capital markets to monitor corporate performance and allocate resources”
(p. 77). As the cost of external finance has fallen, firms have tended to rely
less on internal finance, and thus the value added from internal-capitalmarket
allocation has fallen. Consequently, firms have adopted simpler,
more “focused” structures that rely more heavily on external capital markets
and outsourcing, possibly explaining some of the divestitures observed
in the last two decades.
Are Divestitures Predictable? Evidence from a Duration Study
is section summarizes some ongoing research on the causes of divestiture
(Klein and Klein, 2008). If acquisitions are most often symptoms of managerial
empire-building, as suggested by Ravenscraft and Scherer (1987),
Porter (1987), and other critics, then pre-merger characteristics associated
with high levels of managerial discretion should be systematically related
to the long-term failure and reversal of these acquisitions. In the marketprocess
view, by contrast, long-term performance should be correlated only
with pre-merger characteristics associated with experimentation, rapidly
changing environments, or knowledge-intensive industries. Our empirical
research finds little support for the empire-building hypothesis, and
much stronger support for the market-process view. Specifically, we find
that most characteristics typically associated with empire-building are poor
predictors of merger duration. e evidence also suggests that divestiture
is more likely when the original acquisition is driven by industry-specific
competitive or regulatory shocks.

61
Klein and Klein (2008) study 222 pairs of firms that merged during
the 1977–1983 period. Of the 222 acquisitions, 64, or almost 30 percent,
had been divested by July 1995. We used a duration or “hazard” model
to study the effects of pre-merger characteristics on the time to divestiture.
Duration models help explain how exogenous factors, unobserved factors,
and time itself affect the average duration until some discrete event (in our
case, divestiture) occurs. Duration analysis allows us to see, historically,
how characteristics of the acquiring and acquired firms affect the likelihood
that the acquired firm will later be divested.
To study the effects of pre-merger characteristics on average merger
duration, we estimated a hazard regression of duration (measured as the
natural logarithm of the number of days) on a constant and on a series
of potentially exogenous factors. For assessing the empire-building hypothesis,
we included three characteristics associated with high levels of
managerial discretion: relatedness of target and acquirer, differences in
price-earnings ratios, and the medium of payment. Relatedness addresses
the common view that managers deliberately pursue unrelated targets to
expand their control or make themselves more valuable to the firm. Following
Kaplan and Weisbach (1992), we examined this claim by constructing
a dummy variable equal to one if the acquiring and target firm share
at least one two-digit SIC code and zero otherwise.
Differences in price-earnings ratios are commonly seen as another indicator
of merger motives. Merger critics have often suggested that acquiring
firms grow and prosper by “bootstrapping.” is refers to the practice
whereby bidding firms seek targets with low P/E ratios to boost their reported
earnings per share. It is trivially mathematically true that when a
firm with a high P/E multiple acquires a firm with a low P/E multiple and
pays with its own stock, the acquirer’s earnings per share will rise, simply
because the combined earnings of the two firms will then be divided by a
smaller number of total shares outstanding. Hence, it is argued, acquiring
firms can expand rapidly, with market approval, as managers exploit this
accounting opportunity. 11
11 is is Malkiel’s (1990, p. 58) explanation for the conglomerate boom: “the major
impetus for the conglomerate wave of the 1960s was that the acquisition process itself
could be made to produce growth in earnings per share.... By an easy bit of legerdemain,
[conglomerate managers] could put together a group of companies with no basic potential
at all and produce steadily rising per-share earnings.” For a more balanced discussion of

62
Of course, this argument assumes market participants could be systematically
fooled by a simple algebraic trick. Admittedly, much more
complicated financial and balance-sheet manipulations are often used in
corporate-control transactions: bidders in the 1960s and 1970s sometimes
financed acquisitions with convertible bonds, convertible preferred stocks,
and other unique instruments. Although investors could (and eventually
did) require that earnings be reported on a “fully diluted” basis, to take
account of these manipulations, Malkiel (1990, p. 61) reports that “most
investors in the middle 1960s ignored such niceties and were satisfied only
to see steadily and rapidly rising earnings.” However, there is no evidence
that bootstrapping was either prevalent or successful (Barber, Palmer, and
Wallace, 1995; Matsusaka, 1993).
Nonetheless, we included a measure of relative P/E ratios to see if acquirers
that choose targets with lower P/E ratios are historically more likely
to divest those same targets, implying that bootstrapping does tend to fool
investors, as increases in reported earnings disguise inefficient acquisitions.
We also included a series of dummy variables to represent the medium
of payment used in the merger. Several theories suggest that how an
acquisition is financed can affect performance. First, the bootstrapping
technique described above works only for mergers financed by stock swap.
Second, Jensen (1986) holds that financing takeovers by issuing debt serves
to discipline the acquiring firm’s management by reducing post-merger
discretion in the use of free cash flow. If true, we would expect entrenched
managers to avoid making acquisitions using debt, opting for stock swaps
instead.
In the market-process or experimentation view, by contrast, divestitures
occur when the acquirer receives new information about the target
after the merger has taken place. Plausibly, some relevant characteristics
of potential target firms can be learned only by experience, forcing
entrepreneurs to revise their plans accordingly. What kinds of targets are
most likely to have unknown characteristics? Large firms engage in more
activities than smaller firms, so potential acquirers have more to learn. On
the other hand, smaller firms are less likely to have been written about in
the business press, so one could plausibly argue that private information
is a bigger problem for small targets. 12 We included target size in our
the bootstrapping practice see Lynch (1971, pp. 55–56).
12 However, in our sample, all targets are themselves publicly traded corporations, so

63
regressions to see if either aspect is relevant. Firms in rapidly changing,
knowledge-intensive industries are also likely to have characteristics hidden
from potential acquirers. To capture this effect, we created a dummy
variable based on two-digit SIC codes. e dummy takes a value of one
if the target is in any of the following industries: computers (systems,
software, and services), medical products, communications, aerospace, and
miscellaneous high-tech industries. We also included target R&D because
R&D is difficult to value, especially to outsiders, and thus firms in R&Dintensive
industries are likely to have hidden characteristics. Potential
acquirers would know potential targets’ R&D expenditures (which is reported),
but this may not give the acquirers much information on the
quality of the research or even the content of the R&D.
Finally, unrelated acquisitions, as discussed above, may be a form of experimentation,
as firms try new combinations of activities to find those that
best fit their existing capabilities. Although match-seeking acquisitions are
more likely to be divested, they can still be part of a value-maximizing
acquisition strategy. Our relatedness variable, described above, can proxy
for match-seeking behavior. However, the best way to identify matchseeking
firms is to look directly at historical patterns of acquisitions and
divestitures. A firm with a history of repeated acquisitions and divestitures,
especially acquisitions into unrelated industries, is likely to be a matchseeker,
and thus any current acquisition is more likely to be divested. Unfortunately,
our merger sample is too small to compile detailed acquisition
and divestiture histories on individual acquirers. As a first approximation,
we searched our sample for acquiring firms with at least one previous
acquisition that was later divested within a few years of the acquisition.
We created a dummy variable equal to one if the acquirer in a particular
merger met these criteria, and zero otherwise. 13
As noted above, periods of intense merger activity in particular industries
may be responses to industry-specific competitive or regulatory
shocks. Mitchell and Mulherin (1996), Andrade, et al. (2001), and Andrade
and Stafford (2004) argue that mergers tend to occur in industry
clusters, suggesting that industry-specific factors are important. Mitchell
lack of media exposure is unlikely to be a problem.
13 Mosakowski (1997) suggests that younger firms face greater uncertainty, or a higher
level of “causal ambiguity,” about the best use of their resources, which implies that firm
age could also be a proxy for match-seeking behavior.

64
and Mulherin argue that corporate takeovers are often the most cost-effective
way for industries to respond to these shocks. Moreover, they add,
“because takeovers are driven in part by industry shocks, it is not surprising
that many firms exhibit volatile performance following takeovers, with
actual failures following some negative shocks” (Mitchell and Mulherin,
1996, p. 195).
To capture the effects of industry-specific shocks such as regulatory and
tax changes, we included measures of industry clustering, both for acquirers
and for targets, in our regressions. We did find substantial clustering
in our sample. For example, slightly more than half of the mergers during
the 1977–83 period occurred in only five of the thirty-seven (two-digit)
SIC industries in our sample, both for acquirers and targets, with threequarters
occurring in ten industries. We constructed clustering variables
by counting the number of mergers in each two-digit SIC category in each
year and creating variables for each merger corresponding to the number
of mergers occurring (a) within one year of the merger under observation
(including the year before the merger, the year of the merger, and the year
after the merger, to span a three-year window), (b) within two years of the
merger (a five-year window), and (c) within the entire sample (a seven-year
window). If risky acquisitions or increased levels of experimentation tend
to appear during periods of industry-specific shocks, then these clustering
variables will have negative and significant effects on the length of time to
divestiture.
Our results challenge the empire-building hypothesis and offer evidence
more consistent with the market-process view. Of the variables
associated with agency problems, only relatedness has a statistically significant
effect on merger duration. Neither P/E differences nor the medium
of payment has a statistically significant coefficient in any of several specifications.
e coefficient on relatedness is positive, meaning that related
acquisitions are less likely, on average, to be divested (as in Kaplan and
Weisbach, 1992). However, the coefficient on relatedness is also consistent
with the market-process explanation. Of the five variables associated with
this view, the coefficient on relatedness is positive and significant, the coefficient
on target R&D is negative and significant, and the coefficient on
the match-seeking indicator is negative and significant, all as expected. e
coefficients on target size and the indicator for high-technology industries
have the expected signs (positive and negative, respectively) but are not

65
statistically significant.
Overall, our findings suggest that the divestitures in our sample are
not, on average, the predictable result of unwise acquisitions. Rather,
divestitures follow experimentation and learning, healthy characteristics
of a market economy. Moreover, industry clustering appears to have a
regular effect on average merger duration. e coefficients on our acquirerclustering
variables are consistently negative and statistically significant.
(e coefficients on the target-clustering variables, by contrast, are not
statistically significant.) is suggests that volatile performance does follow
shocks, as suggested by Mitchell and Mulherin (1996).
is finding is consistent with the view that firms make acquisitions
when faced with increased uncertainty (see Spulber, 1992, pp. 557–59).
Regulatory interference could be a major cause of such uncertainty. As discussed
above, government intervention makes economic calculation more
difficult, and can ultimately render calculation impossible. When faced
with increased regulatory interference, firms apparently respond by experimenting,
making riskier acquisitions, and consequently making more
mistakes, ex post.
Conclusions
Do entrepreneurs make predictable mistakes? eory and evidence suggest
otherwise. Contrary to the conventional wisdom on mergers and sell-offs,
divestitures of previously acquired assets do not necessarily indicate that
the original acquisitions were mistakes. Indeed, empire-building motives
do not seem to be systematically related to long-term merger performance.
Instead, divestitures are more likely to be associated with experimentation,
learning, and other socially beneficial activities.
Acquisitions are uncertain endeavors, and the entrepreneur-promoter
—along with the manager to whom he delegates authority—is a speculator.
If the consequences of his actions were determinate, he would not be an
entrepreneur, but rather, as some economic theories seem to treat him, “a
soulless automaton” (Mises, 1949, p. 582). However, the future can never
be known with certainty; long-term profit and loss cannot be predicted
based on current information. As Mises explains:
What distinguishes the successful entrepreneur and promoter from
other people is precisely the fact that he does not let himself be

66
guided by what was and is, but arranges his affairs on the ground
of his opinion about the future. He sees the past and the present as
other people do; but he judges the future in a different way. (p. 585)
As discussed above, it is hardly surprising that these judgments are
less than perfect. e relevant question for policy is whether there is a
feasible alternative to market-based corporate governance. Our reading of
the political-economy literature leaves us doubtful that such an alternative
exists.

CHAPTER 4
The Entrepreneurial Organization of
Heterogeneous Capital †
With Kirsten Foss, Nicolai J. Foss, and Sandra K. Klein
e theory of entrepreneurship comes in many guises. Management scholars
and economists have made the entrepreneur an innovator, a leader, a
creator, a discoverer, an equilibrator, and more. In only a few of these
theories, however, is entrepreneurship explicitly linked to asset ownership
(examples include Casson, 1982; Foss, 1993b; Foss and Klein, 2005;
Knight, 1921; Langlois and Cosgel, 1993; Mises, 1949). Ownership theories
of entrepreneurship start with the proposition that entrepreneurial
judgment is costly to trade, an idea originally suggested by Knight (1921).
When judgment is complementary to other assets, it makes sense for entrepreneurs
to own these complementary assets. e entrepreneur’s role,
then, is to arrange or organize the capital goods he owns. Entrepreneurial
judgment is ultimately judgment about the control of resources.
In a world of identical capital goods, entrepreneurial judgment plays a
relatively minor role. Unfortunately, mainstream neoclassical economics,
† Published originally in Journal of Management Studies 44, no. 7 (November 2007):
1165–86.
67

68
upon which most economic theories of entrepreneurship are based, lacks a
systematic theory of capital heterogeneity. Strongly influenced by Knight’s
(1936) concept of capital as a permanent, homogeneous fund of value,
rather than a discrete stock of heterogeneous capital goods, neoclassical
economists have devoted little attention to capital theory. For this reason,
ownership theories of entrepreneurship, as well as contemporary theories
of firm boundaries, ownership, and strategy, are not generally founded on
a systematic theory of capital or asset attributes. is chapter outlines the
capital theory associated with the Austrian school of economics and derives
implications for entrepreneurship and economic organization.
e Austrian school of economics (Menger, 1871; Böhm-Bawerk,
1889; Mises, 1949; Hayek, 1948, 1968b; Kirzner, 1973; Lachmann,
1956; Rothbard, 1962) is well known in management studies for its
contributions to the theory of entrepreneurship and the complementary
“market process” account of economic activity (Chiles, 2003; Chiles and
Choi, 2000; Hill and Deeds, 1996; Jacobson, 1992; Langlois, 2001;
Roberts and Eisenhardt, 2003). Other characteristically Austrian ideas
such as the time structure of capital and the “malinvestment” theory of
the business-cycle theory have received much less attention. To several
Austrians, the theory of entrepreneurship was closely related to the theory
of capital. As Lachmann (1956, pp. 13, 16) argued: “We are living in a
world of unexpected change; hence capital combinations . . . will be ever
changing, will be dissolved and reformed. In this activity, we find the real
function of the entrepreneur.” It is this “real function” that we elaborate
in the following.
Management scholars will hardly be startled by the claim that entrepreneurs
organize heterogeneous capital goods. e management literature
abounds with notions of heterogeneous “resources,” “competencies,”
“capabilities,” “assets,” and the like. Linking such work to entrepreneurship
would seem to be a rather natural undertaking (see, e.g. Alvarez and
Busenitz, 2001). However, modern theories of economic organization are
not built on a unified theory of capital heterogeneity; instead, they simply
invoke ad hoc specificities when necessary. e Austrian school offers
a systematic, comprehensive theory of capital, and Austrian notions of
capital heterogeneity can inform, synthesize, and improve the treatment
of specificities in the theory of the firm. Adopting the Austrian view of
capital also reveals new sources of transaction costs that influence economic

69
organization.
e chapter proceeds as follows. We begin, building on Foss and Klein
(2005), by linking the theory of entrepreneurship and the theory of the
firm. e link involves first, defining entrepreneurship as the exercise of
judgment over resource uses under uncertainty, and second, viewing the
theory of economic organization as a subset of the theory of asset ownership.
We then discuss “assets” in the specific context of capital theory,
showing that the assumption of heterogeneous capital is necessary to the
theory of the firm. We next summarize the Austrian theory of capital,
elaborating and expanding on those parts of the theory most relevant for
economic organization. e final section weaves these elements together
to provide new insights into key questions of the emergence, boundaries,
and internal organization of the firm. We conclude with some suggestions
for testable implications that may be drawn from our theory.
Entrepreneurship, Judgment, and Asset Ownership
Entrepreneurs are the founders and developers of business firms. Indeed,
the establishment of a new business venture is the quintessential manifestation
of entrepreneurship. Yet, as Foss and Klein (2005) point out, the
theory of entrepreneurship and the theory of the firm developed largely
in isolation. e economic theory of the firm emerged and took shape as
the entrepreneur was being banished from microeconomic analysis, first
in the 1930s when the firm was subsumed into neoclassical price theory
(O’Brien, 1984) and again in the 1980s as the theory of the firm was
restated using game theory and information economics. Modern contributions
to the theory of the firm (Hart, 1995; Milgrom and Roberts,
1992; Williamson, 1975, 1985, 1996) mention entrepreneurship only in
passing, if at all.
Foss and Klein (2005) show how the theory of entrepreneurship and
the theory of the firm can be linked using the concept of entrepreneurship
as judgment. 1 is view traces its origins to the first systematic treatment
of entrepreneurship in economics, Richard Cantillon’s Essai sur la nature
de commerce en géneral (1755). It conceives entrepreneurship as judgmental
decision making under conditions of uncertainty. Judgment refers
1 For related treatments along the same lines, see Casson (1982) and Langlois and
Cosgel (1993).

70
primarily to business decision making when the range of possible future
outcomes, let alone the likelihood of individual outcomes, is generally
unknown (what Knight terms uncertainty, rather than mere probabilistic
risk). More generally, judgment is required “when no obviously correct
model or decision rule is available or when relevant data is unreliable or
incomplete” (Casson, 1993).
As such, judgment is distinct from boldness, daring, or imagination
(Aldrich and Wiedenmayer, 1993; Begley and Boyd, 1987; Chandler and
Jansen, 1992; Hood and Young, 1993; Lumpkin and Dess, 1996), innovation
(Schumpeter, 1911), alertness (Kirzner, 1973), leadership (Witt,
1998), and other concepts of entrepreneurship that appear in the economics
and management literatures. Judgment must be exercised in mundane
circumstances, as Knight (1921) emphasized, for ongoing operations
as well as new ventures. Alertness is the ability to react to existing opportunities
while judgment refers to the creation of new opportunities. 2
ose who specialize in judgmental decision making may be dynamic,
charismatic leaders, but they need not possess these traits. In short, decision
making under uncertainty is entrepreneurial, whether it involves
imagination, creativity, leadership, and related factors or not.
Knight (1921) introduces judgment to link profit and the firm to uncertainty.
Judgment primarily refers to the process of businessmen forming
estimates of future events in situations in which the relevant probability
distributions are themselves unknown. Entrepreneurship represents
judgment that cannot be assessed in terms of its marginal product and
which cannot, accordingly, be paid a wage (Knight, 1921, p. 311). In
other words, there is no market for the judgment that entrepreneurs rely
on, and therefore exercising judgment requires the person with judgment
to start a firm. Of course, judgmental decision-makers can hire consultants,
forecasters, technical experts, and so on. However, as we explain
below, in doing so they are exercising their own entrepreneurial judgment.
Judgment thus implies asset ownership, for judgmental decision making
is ultimately decision making about the employment of resources. An
2 In Kirzner’s treatment, entrepreneurship is characterized as “a responding agency. I
view the entrepreneur not as a source of innovative ideas ex nihilo, but as being alert to
the opportunities that exist already and are waiting to be noticed” (Kirzner, 1973, p. 74,
emphasis in original)

71
entrepreneur without capital goods is, in Knight’s sense, no entrepreneur. 3
e notion of entrepreneurship as judgment implies an obvious link
with the theory of the firm, particularly those theories (transaction cost
economics and the property-rights approach) that put asset ownership at
the forefront of firm organization (Hart 1995; Williamson 1996; cf. also
Langlois and Cosgel 1993). e firm is defined as the entrepreneur plus
the alienable assets he owns and therefore ultimately controls. e theory
of the firm then becomes a theory of how the entrepreneur arranges his
heterogeneous capital assets, what combinations of assets will he seek to
acquire, what (proximate) decisions will he delegate to subordinates, how
will he provide incentives and use monitoring to see that his assets are
used consistently with his judgments, and so on. Given this emphasis on
entrepreneurship, one might expect the modern theory of the firm to be
based on a coherent, systematic theory of capital. is is not the case,
however.
Capital Theory and the Theory of the Firm
Shmoo Capital and Its Implications
Modern (neoclassical) economics focuses on a highly stylized model of the
production process. e firm is a production function, a “black box” that
transforms inputs (land, labor, capital) into output (consumer goods). We
noted in chapters 1 and 2 that this model omits the critical organizational
details of production, rarely looking inside the black box to see how hierarchies
are structured, how incentives are provided, how teams are organized,
and the like. An equally serious omission, perhaps, is that production
is treated as a one-stage process, in which factors are instantly converted
into final goods, rather than a complex, multi-stage process unfolding
through time and employing rounds of intermediate goods. “Capital”
is treated as a homogeneous factor of production, the K that appears in
the production function along with L for labor. Following Solow (1957)
models of economic growth typically model capital as what Paul Samuelson
called “shmoo”—an infinitely elastic, fully moldable factor that can be
3 is contrasts with Schumpeter’s and Kirzner’s conceptions of entrepreneurship, in
which entrepreneurship can be exercised without the possession of any capital goods. On
this contrast, see Foss and Klein (2005).

72
substituted costlessly from one production process to another.
In a world of shmoo capital, economic organization is relatively unimportant.
All capital assets possess the same attributes, and thus the costs of
inspecting, measuring, and monitoring the attributes of productive assets
is trivial. Exchange markets for capital assets would be virtually devoid
of transaction costs. A few basic contractual problems—in particular,
principal–agent conflicts over the supply of labor services—may remain,
though workers would all use identical capital assets, and this would greatly
contribute to reducing the costs of measuring their productivity.
While transaction costs would not disappear entirely in such a world,
asset ownership would be relatively unimportant. e possibility of specifying
all possible uses of an asset significantly reduces the costs of writing
complete, contingent contracts between resource owners and entrepreneurs
governing the uses of the relevant assets. 4 Contracts would largely
substitute for ownership, leaving the boundary of the firm indeterminate
(Hart, 1995).
Capital in Modern Theories of the Firm
By contrast, all modern theories of the firm assume (often implicitly) that
capital assets possess varying attributes, so that all assets are not equally
valuable in all uses. Here we review how capital heterogeneity leads to
non-trivial contracting problems, the solutions to which may require the
creation of a firm.
ASSET SPECIFICITY APPROACHES. In transaction cost economics (TCE)
(Williamson, 1975, 1985, 1996) and the “new” property-rights approach
(Grossman and Hart, 1986; Hart and Moore, 1990), some assets are
conceived as specific to particular users. If complete, contingent contracts
specifying the most valuable uses of such assets in all possible states of the
world cannot be written, then owners of productive assets face certain risks.
4 Contracts might still be incomplete because contracting parties have different, subjective
expectations about the likelihood of various contingencies affecting the value of
the (homogeneous) capital asset. Agents may also differ in their ability to learn about
possible uses of the capital good. In other words, Knightian uncertainty plus bounded
rationality could drive contractual incompleteness even in a world without capital heterogeneity.
However, the neoclassical world of shmoo capital is characterized by parametric
uncertainty, common priors, and hyperrationality.

73
Primarily, if circumstances change unexpectedly, the original governing
agreement may no longer be effective. e need to adapt to unforeseen
contingencies constitutes an important cost of contracting. Failure to
adapt imposes what Williamson (1991b) calls “maladaptation costs,” the
best known of which is the “holdup” problem associated with relationshipspecific
investments.
It is obvious that maladaptation costs largely disappear if all assets are
equally valuable in all uses. Potential holdup would still be a concern
for owners of relationship-specific human capital and raw materials, but
disagreements over the efficient use of capital goods would become irrelevant.
5 e scope of entrepreneurial activity would also be severely reduced,
since entrepreneurs would have no need to arrange particular combinations
of capital assets.
RESOURCE- AND KNOWLEDGE-BASED APPROACHES. Resource-based (Barney,
1991; Lippman and Rumelt, 2003; Wernerfelt, 1984) and knowledgebased
(Grant, 1996; Penrose, 1959) approaches also emphasize capital
heterogeneity, but their focus is not generally economic organization, but
rather competitive advantage. 6 e emphasis in these approaches is not
economic organization, however, but competitive advantage. e latter
is seen as emerging from bundles of resources (including knowledge).
Different resource bundles are associated with different efficiencies translating
into a theory of competitive advantage. Resource- and knowledgebased
scholars often emphasize that heterogeneous assets do not give rise
independently to competitive advantages. Rather, it is the interactions
among these resources, their relations of specificity and co-specialization,
that generate such advantages (e.g. Barney, 1991; Black and Boal, 1994;
Dierickx and Cool, 1989). However, this notion is not developed from
any comprehensive perspective on asset specificity and co-specialization
(or complementarity) (as in Teece, 1982).
5 Resources that are initially homogeneous could become heterogeneous over time,
through learning by doing or co-specialization of human and physical capital. Here we
refer to conditions of permanent homogeneity.
6 Penrose’s approach, unlike modern resource- and knowledge-based approaches, did
emphasize one important element of economic organization, namely the rate of growth of
the firm.

74
“OLD” PROPERTY RIGHTS THEORY. A sophisticated approach to capital heterogeneity
can be drawn from the property-rights approach associated with
economists such as Coase (1960), Alchian (1965), Demsetz (1964, 1967),
and, particularly, Barzel (1997). ese writers focus not on individual
assets per se, but on bundles of asset attributes to which property rights
may be held (Foss and Foss, 2001).
While it is common to view capital heterogeneity in terms of physical
heterogeneity—beer barrels and blast furnaces are different because of
their physical differences—the old property-rights approach emphasizes
that capital goods are heterogeneous because they have different levels and
kinds of valued attributes (in the terminology of Barzel, 1997). 7 Attributes
are characteristics, functions, or possible uses of assets, as perceived by an
entrepreneur. For example, a copying machine has multiple attributes because
it can be used at different times, by different people, and for different
types of copying work; that it can be purchased in different colors and sizes;
and so on. 8 Property rights to the machine itself can be partitioned, in the
sense that rights to its attributes can be defined and traded, depending on
transaction costs (Foss and Foss, 2001).
Clearly, virtually all assets have multiple attributes. Assets are heterogeneous
to the extent that they have different, and different levels of, valued
attributes. Attributes may also vary over time, even for a particular asset.
In a world of “true” uncertainty, entrepreneurs are unlikely to know all
relevant attributes of all assets when production decisions are made. Nor
can the future attributes of an asset, as it is used in production, be forecast
with certainty. Future attributes must be discovered, over time, as assets
are used in production. Or, to formulate the problem slightly differently,
future attributes are created as entrepreneurs envision new ways of using
assets to produce goods and services. 9
7 Foss and Foss (2005) link the property rights approach to the resource-based view,
demonstrating how the more “micro” approach of the property rights approach provides
additional insights into resource value. See also Kim and Mahoney (2002, 2005) for similar
arguments.
8 Clearly, this notion of subjectively perceived attributes of capital assets is related to
Penrose’s (1959) point that physically identical capital assets may yield different services,
depending on, for example, the nature of the administrative framework in which they are
embedded.
9 In this chapter we do not distinguish between “discovery” and “creation” as alternative
conceptions of the entrepreneurial act (Alvarez and Barney, 2007). Chapter 5 below
discusses this distinction in detail.

75
SUMMING UP. While capital heterogeneity thus plays an important role
in transaction cost, resource-based, and property-rights approaches to the
firm, none of these approaches rests on a unified, systematic theory of
capital. Instead, each invokes the needed specificities in an ad hoc fashion
to rationalize particular trading problems for transaction cost economics,
asset specificity; for capabilities theories, tacit knowledge; and so on. Some
writers (Demsetz, 1991; Langlois and Foss, 1999; Winter, 1988) argue that
the economics of organization has shown a tendency (albeit an imperfect
one) to respect an implicit dichotomy between production and exchange.
us, as Langlois and Foss (1999) argue, there is an implicit agreement,
that the production function approach with its attendant assumptions (e.g.
blueprint, knowledge) tells us what we need to know about production, so
theories of the firm can focus on transacting and how transactional hazards
can be mitigated by organization. Production issues, including capital
theory, never really take center stage. is is problematic if production
itself reveals new problems of transacting that may influence economic
organization.
The Attributes Approach to Capital Heterogeneity
An alternative tradition in economics, the Austrian school, does have a systematic,
comprehensive theory of capital, though it has not generally been
applied to the business firm. 10 Instead, most of the substantial literature on
Austrian capital theory focuses on the economy’s overall capital structure
and how money and credit markets affect the allocation of resources across
different stages of the production process. 11
Austrian Capital Theory
e concept of heterogeneous capital has a long and distinguished place
in Austrian economics. 12 Early Austrian writers argued that capital has
10 Of the several dozen papers on Austrian economics and the theory of the firm (including,
for instance, the papers collected in Foss and Klein, 2002), only a few deal with
Austrian capital theory (see Chiles, Meyer, and Hench, 2004; Lewin, 2005; Yu, 1999; and
various papers by the present authors)
11 Hayek’s 1974 Nobel Prize in economics was awarded for his technical work on the
business cycle and not, as is commonly believed, for his later work on knowledge and
“spontaneous order.” For a modern restatement of Austrian business cycle theory, see
Garrison (2000).
12 For overviews see Strigl (1934), Kirzner (1966), and Lewin (1999).

76
a time dimension as well as a value dimension. Carl Menger (1871),
founder of the Austrian school, characterized goods in terms of “orders”:
goods of lowest order are those consumed directly. Tools and machines
used to produce those consumption goods are of a higher order, and the
capital goods used to produce the tools and machines are of an even higher
order. Building on his theory that the value of all goods is determined by
their ability to satisfy consumer wants (i.e. their marginal utility), Menger
showed that the value of the higher-order goods is given or “imputed” by
the value of the lower-order goods they produce. Moreover, because certain
capital goods are themselves produced by other, higher-order capital
goods, it follows that capital goods are not identical, at least by the time
they are employed in the production process. e claim is not that there is
no substitution among capital goods, but that: the degree of substitution
is limited; as Lachmann (1956) put it, capital goods are characterized by
“multiple specificity.” Some substitution is possible, but only at a cost. 13
Kirzner (1966) added an important refinement to the Austrian theory
of capital by emphasizing the role of the entrepreneur (the theme that
dominates Kirzner’s later, better known, work). Earlier Austrian writers,
particularly Böhm-Bawerk, tried to characterize the economy’s capital
structure in terms of its physical attributes, Böhm-Bawerk attempted to
describe the temporal “length” of the structure of production by a single
number, the “average period of production.” Kirzner’s approach avoids
these difficulties by defining capital assets in terms of subjective, individual
production plans, plans that are formulated and continually revised by
profit-seeking entrepreneurs. Capital goods should thus be characterized,
not by their physical properties, but by their place in the structure of
13 Hayek’s Prices and Production (1931) emphasized the relationship between the value
of capital goods and their place in the temporal sequence of production. Because production
takes time, factors of production must be committed in the present for making
final goods that will have value only in the future after they are sold. However, capital
is heterogeneous. As capital goods are used in production, they are transformed from
general-purpose materials and components to intermediate products specific to particular
final goods. Consequently, these assets cannot be easily redeployed to alternative uses
if demands for final goods change. e central macroeconomic problem in a modern
capital-using economy is thus one of intertemporal coordination: how can the allocation
of resources between capital and consumer goods be aligned with consumers’ preferences
between present and future consumption? In e Pure eory of Capital (1941) Hayek
describes how the economy’s structure of production depends on the characteristics of
capital goods durability, complementarity, substitutability, specificity, and so on.

77
production as conceived by entrepreneurs. e actual place of any capital
good in the time sequence of production is given by the market for capital
goods, in which entrepreneurs bid for factors of production in anticipation
of future consumer demands. is subjectivist, entrepreneurial approach
to capital assets is particularly congenial to theories of the firm that focus
on entrepreneurship and the ownership of assets. 14
Understanding Capital Heterogeneity
e Austrian approach to capital generated considerable controversy, both
within the school itself and between the Austrians and rival schools of economic
thought. Given the attention devoted to the problem of measuring
a heterogeneous capital stock, it is surprising that relatively little analytical
effort has been devoted to the concept of heterogeneity itself. e notion
of heterogeneous capital is crucial not just for Austrian capital theory, but
for (Austrian) economics in general. For example, the Austrian position
in the socialist calculation debate of the 1930s (Hayek, 1933a; Mises,
1920) is based on an entrepreneurial concept of the market process, one in
which the entrepreneur’s primary function is to choose among the various
combinations of factors suitable for producing particular goods (and to
decide whether these goods should be produced at all), based on current
prices for the factors and expected future prices of the final goods. If
capital is shmoo with one price, then entrepreneurship is reduced to choosing
between shmoo-intensive and labor-intensive production methods (or
among types of labor), a problem a central planner could potentially solve.
e failure of socialism, in Mises’s (1920) formulation, follows precisely
from the complexity of the economy’s capital structure, and the subsequent
need for entrepreneurial judgment. As Lachmann (1956, p. 16) points
out, real-world entrepreneurship consists primarily of choosing among
combinations of capital assets:
[T]he entrepreneur’s function ... is to specify and make decisions
14 Penrose (1959) also emphasizes the subjectivity of the firm’s perceived opportunity set
(Kor and Mahoney, 2000). In her approach, entrepreneurs must learn how best to deploy
their productive resources; because learning is idiosyncratic, firms with similar stocks of
physical resources may differ in their strategic opportunities. Our emphasis on subjectively
perceived attributes of capital assets may be seen as an example of a Penrosian perceived
‘opportunity’ set. Kirzner’s concept of entrepreneurial “alertness,” by contrast, is not a
learned skill, but a talent or ability that is not subject to further explanation.

78
on the concrete form the capital resources shall have. He specifies
and modifies the layout of his plant.... As long as we disregard the
heterogeneity of capital, the true function of the entrepreneur must
also remain hidden.
Kirzner’s argument that capital goods are heterogeneous not because of
their objective characteristics, but because they play particular roles within
the entrepreneur’s overall production plan, further developed the link between
entrepreneurship and capital heterogeneity.
In our interpretation, as discussed above and in Foss and Foss (2001),
capital goods are distinguished by their attributes, using Barzel’s (1997)
terminology. As Alchian and Demsetz (1972, p. 793) note, “[e]fficient
production with heterogeneous resources is a result not of having better resources
but in knowing more accurately the relative productive performances
of those resources.” Contra the production function view in basic neoclassical
economics, such knowledge is not given, but has to be created or discovered.
Even in the literature on opportunity creation and exploitation,
in which entrepreneurial objectives are seen as emerging endogenously
from project champions’ creative imaginations, entrepreneurial means (resources)
are typically taken as given (see, for example Sarasvathy, 2001).
Heterogeneous Assets, Property Rights, and Ownership
Focusing on attributes not only helps conceptualize heterogeneous capital,
but also illuminates the vast literature on property rights and ownership.
Barzel (1997) stresses that property rights are held over attributes; in his
work, property rights to known attributes of assets are the relevant units
of analysis. In contrast, he dismisses the notion of asset ownership as
essentially legal and extra-economic. Similarly, Demsetz (1988a, p. 19)
argues that the notion of “full private ownership” over assets is “vague,” and
“must always remain so” because “there is an infinity of potential rights of
actions that can be owned. . . . It is impossible to describe the complete set
of rights that are potentially ownable.”
However, as we noted above, most assets have unspecified, unknown
future attributes, and an important function of entrepreneurship is to create
or discover these attributes. Contrary to Demsetz, it is exactly this
feature that creates a distinct role for asset ownership, the acquisition of
legal title to a bundle of existing and future attributes. Specifically, own-

79
ership is a low-cost means of allocating the rights to attributes of assets
that are created or discovered by the entrepreneur-owner. For instance,
those who create or discover new knowledge have an incentive to use it
directly because it is costly to transfer knowledge to others. In a wellfunctioning
legal system, ownership of an asset normally implies that the
courts will not interfere when an entrepreneur-owner captures the value of
newly created or discovered attributes of an asset he owns. Consequently,
the entrepreneur-owner can usually avoid costly negotiation with those
who are affected by his creation or discovery. Moreover, asset ownership
itself provides a powerful incentive to create or discover new attributes,
as ownership conveys the legally recognized (and at least partly enforced)
right to the income of an asset, including the right to income from new
attributes.
Heterogeneous Capital and Experimental Entrepreneurship
e Austrian idea of heterogeneous capital is thus a natural complement
to the theory of entrepreneurship. 15 Entrepreneurs who seek to create or
discover new attributes of capital assets will want ownership titles to the
relevant assets, both for speculative reasons and for reasons of economizing
on transaction costs. ese arguments provide room for entrepreneurship
that goes beyond deploying a superior combination of capital assets with
“given” attributes, acquiring the relevant assets, and deploying these to
producing for a market; entrepreneurship may also be a matter of experimenting
with capital assets in an attempt to discover new valued attributes.
Such experimental activity may take place in the context of trying out
new combinations through the acquisition of or merger with other firms,
or in the form of trying out new combinations of assets already under the
control of the entrepreneur. e entrepreneur’s success in experimenting
with assets in this manner depends not only on his ability to anticipate
future prices and market conditions, but also on internal and external
transaction costs, the entrepreneur’s control over the relevant assets, how
much of the expected return from experimental activity he can hope to
15 We note in passing that the understanding of management may also be furthered by
beginning from heterogeneous capital assets and the need for coordination they imply.
From a resource-based view, Mahoney (1995) argues that an important function of management
is the coordination of such assets.

80
appropriate, and so on. Moreover, these latter factors are key determinants
of economic organization in modern theories of the firm, which
suggests that there may be fruitful complementarities between the theory
of economic organization and Austrian theories of capital heterogeneity
and entrepreneurship.
Organizing Heterogeneous Capital
Here we show how Austrian notions of capital heterogeneity give additional
insights into the theory of the firm. e key questions are why
firms emerge and what explains their boundaries (scope) and internal organization.
In the following, we relate these issues to our emphasis on
entrepreneurship as judgment about organizing and using heterogeneous
capital assets.
The Emergence of the Firm
Coase (1937) explained the firm as a means for economizing on transaction
costs, a theme elaborated by Williamson (1975, 1985, 1996). Alchian
and Demsetz (1972) viewed the firm as an (albeit imperfect) solution to
the free-rider problem in team production. Resource-based theories emphasize
the need to generate and internalize tacit knowledge. It is not
obvious where the entrepreneur fits into these approaches, however. Our
framework suggests a slightly different approach.
INCOMPLETE MARKETS FOR JUDGMENT. Agents may realize rents from their
human capital through three means: (1) selling labor services on market
conditions; (2) entering into employment contracts; or (3) starting a firm.
As Barzel (1987) argues, moral hazard implies that options (1) and (2) are
often inefficient means of realizing rents. In other words, entrepreneurs
know themselves to be good risks but are unable to communicate this to the
market. For this reason, firms may emerge because the person whose services
are the most difficult to measure (and therefore are most susceptible to
moral hazard and adverse selection) becomes an entrepreneur, employing
and supervising other agents, and committing capital of his own to the
venture, thus contributing a bond.
However, there are other reasons why the market may not be able to
evaluate entrepreneurial services. For example, Kirzner (1979, p. 181) ar-

81
gues that “entrepreneurship reveals to the market what the market did not
realize was available, or indeed, needed at all.” Casson (1982, p. 14) takes a
more Schumpeterian position, arguing that “[t]he entrepreneur believes he
is right, while everyone else is wrong. us the essence of entrepreneurship
is being different because one has a different perception of the situation”
(see also Casson, 1997). In this situation, non-contractibility arises because
“[t]he decisive factors . . . are so largely on the inside of the person making
the decision that the ‘instances’ are not amenable to objective description
and external control” (Knight, 1921, p. 251). Hence moral hazard is not
the only important factor underlying non-contractibility. An agent may
be unable to communicate his “vision” of a commercial experiment as
a specific way of combining heterogeneous capital assets to serve future
consumer wants in such a way that other agents can assess its economic
implications. In such a case, he cannot be an employee, but will instead
start his own firm. e existence of the firm can thus be explained by a
specific category of transaction costs, namely, those that close the market
for entrepreneurial judgment.
Note that in a world of uncertainty and change, these factors explain
not only the emergence of new firms, but also the ongoing operations
of existing firms. e entrepreneurial process of combining and recombining
heterogeneous resources plays out continually, through time, as
new attributes are created or discovered (and as consumer preferences and
technological capabilities change). In our framework, the entrepreneurial
act is not restricted to new venture formation; entrepreneurial judgment is
necessarily exercised on an ongoing basis. Our approach is thus inconsistent
with what we perceive as an undue emphasis on new venture creation
in the applied entrepreneurship literature.
Finally, there is an important sense in which judgment can never be
fully delegated. Resource owners, by possessing residual rights of control,
are the decision-makers of last resort, no matter how many day-to-day decision
rights they delegate to hired managers. Jensen (1989) famously distinguished
“active” from “passive” investors. Active investors are those “who
hold large equity or debt positions, sit on boards of directors, monitor and
sometimes dismiss management, are involved with the long-term strategic
direction of the companies they invest in, and sometimes manage the
companies themselves” Jensen (1989, p. 65). While not denying the importance
of this distinction, we argue that residual control rights make all

82
resource owners “active,” in the sense that they must exercise judgment over
the use of their resources. In our approach, investors choose how “Jensenactive”
they wish to be, which makes them “active” by definition. 16
FIRMS AS CONTROLLED EXPERIMENTS. e idea of incomplete markets for
judgment helps us understand the one-person firm. However, similar
ideas may also be useful for understanding the multi-person firm. For
instance, as discussed above, when capital is homogenous it is easy to
conceive, coordinate, and implement plans for producing, marketing, and
selling goods and services. e decision problem is one of choosing the
intensities with which shmoo is applied to various activities. In the real
world of heterogeneous capital assets, by contrast, production plans are
much more difficult to conceive, coordinate, and implement. It is not
necessarily obvious to which activities capital goods are most profitably
applied and account has to be taken of complex relations between capital
goods.
Given that the optimal relationships among assets are generally unknown
ex ante, and often so complex that resorting to analytical methods
is not possible (Galloway, 1996), some experimentation is necessary. First,
one must isolate the system boundaries, that is, where the relevant relationships
among assets are most likely to be. Second, the experimental process
must be like a controlled experiment (or a sequence of such experiments)
to isolate the system from outside disturbances. ird, there must be some
sort of guidance for the experiment. is may take many forms, ranging
from centrally provided instructions to negotiated agreements to shared
understandings of where to begin experimenting, how to avoid overlapping
experiments, how to revise the experiment in light of past results, and so
on. e central problem is how this experimental process is best organized.
Does the need for experimentation help explain the existence of the firm,
or can such experimentation be organized efficiently through markets?
In a world of complete knowledge and zero transaction costs, all rights
to all uses of all assets could be specified in contracts. By contrast, in a
world of heterogeneous assets with attributes that are costly to measure and
partly unforeseen, complete contracts cannot be drafted. e resulting set
of incomplete contracts may constitute a firm, a process of coordination
16 See the discussion in chapter 2 above on “Firms as Investments” and “Financiers as
Entrepreneurs.”

83
managed by the entrepreneur’s central direction. If relationship-specific
assets are involved, the holdup problem described above becomes a serious
concern.
us, asset specificity may itself be an outcome of an experimental process.
To be sure, Williamson (e.g., 1985, 1996) clearly allows for intertemporal
considerations relating to what he calls the “fundamental transformation”
(i.e., the transformation of large numbers to small numbers situation,
and therefore the emergence of asset specificity). However, he
doesn’t describe this process in much detail. In the present approach,
as experimental activity provides information about how to organize the
system, assets will be increasingly specific in time and location. Temporal
and site specificity will tend to increase as assets become more efficiently
coordinated. is provides one rationale for organizing the experiments
inside firms. Firms may also be justified by problems associated with the
dispersion of knowledge across agents. Production systems may exhibit
multiple equilibria, and it may not be obvious how to coordinate on a
particular equilibrium or even which equilibria are preferred.
In principle, an experimenting team could hire an outside consultant
who guides the experimental activity, giving advice on the sequence of
actions and asset uses, initiating the experiments, drawing the appropriate
conclusions from each experiment, determining how these conclusions
should influence further experimentation, and so on. However, such an
arrangement is likely to run into serious bargaining costs. Under market
contracting any team member can veto the advice provided by the consultant,
and submitting to authority may be the least costly way to organize
the experimental activity. “Authority” here means that the entrepreneur
has the right to redefine and reallocate decision rights among team members
and to sanction team members who do not use their decision rights
efficiently. By possessing these rights, entrepreneur-managers can conduct
experiments without continuously having to renegotiate contracts, saving
bargaining and drafting costs. Such an arrangement then provides a setting
for carrying out “controlled” experiments in which the entrepreneurmanager
changes only some aspects of the relevant tasks to trace the effects
of specific rearrangements of rights. Establishing these property rights is
tantamount to forming a firm.

84
The Boundaries of the Firm
In the approach developed in this chapter, the theory of firm boundaries is
closely related to the theory of entrepreneurship. Mergers, acquisitions, divestitures,
and other reorganizations can generate efficiencies by replacing
poorly performing managers, creating operating synergies, or establishing
internal capital markets. Like other business practices that do not conform
to textbook models of competition, mergers, acquisitions, and financial
restructurings have long been viewed with suspicion by some commentators
and regulatory authorities. However, the academic literature clearly
suggests that corporate restructurings do, on average, increase shareholder
value (Jarrell, et al., 1988; Andrade, et al., 2001). Given such benefits, why
are many mergers later “reversed” in a divestiture, spin-off, or carve-out?
Chapter 3 above distinguishes between two basic views. e first, a kind
of empire building, holds that entrenched managers make acquisitions
primarily to increase their own power, prestige, or control, producing
negligible efficiency gains, and that acquisitions by manager-controlled
firms are likely to be divested ex post. An alternative view acknowledges that
unprofitable acquisitions may be “mistakes” ex post, but argues that poor
long-term performance does not indicate ex ante inefficiency. A divestiture
of previously acquired assets may mean simply that profit-seeking entrepreneurs
have updated their forecasts of future conditions or otherwise
learned from experience. ey are adjusting structure of heterogeneous
capital assets specific to their firms.
Chapter 3 discusses empirical evidence that the long-term success or
failure of corporate acquisitions cannot, in general, be predicted by measures
of manager control or principal–agent problems. However, significantly
higher rates of divestiture tend to follow mergers that occur in a
cluster of mergers in the same industry. As argued by Mitchell and Mulherin
(1996), Andrade, et al. (2001), and Andrade and Stafford (2004),
mergers frequently occur in industry clusters, suggesting that mergers are
driven in part by industry-specific factors, such as regulatory shocks. When
an industry is regulated, deregulated, or re-regulated, economic calculation
becomes more difficult, and entrepreneurial activity is hampered. It should
not be surprising that poor long-term performance is more likely under
those conditions.

85
Internal Organization
As Foss and Klein (2005) point out, most existing approaches to entrepreneurship,
even if linked to the existence of firms, say little about the
key questions of internal organization: How should decision rights be assigned?
How should employees be motivated and evaluated? How should
firms be divided into divisions and departments? e notion of judgmentbased
entrepreneurship offers insight into these questions as well.
PRODUCTIVE AND DESTRUCTIVE ENTREPRENEURSHIP. Consider first the
way firm structure affects the exercise of entrepreneurial judgment—or a
proxy version of such judgment—within the organization. In much of
the entrepreneurship literature, there is a general, though usually implicit
claim that all entrepreneurial activity is socially beneficial (Kirzner, 1973;
Mises, 1949). However, as Baumol (1990) and Holcombe (2002) point
out, entrepreneurship may be socially harmful if it takes the form of
rent-seeking, attempts to influence governments (or management) to
redistribute income in a way that consumes resources and brings about
a social loss. It is therefore necessary to introduce a distinction between
productive and destructive entrepreneurship.
In the context of firm organization, “destructive entrepreneurship” can
refer to agents’ effort to create or discover new attributes and take control
over these in such a way that firm value is reduced. us, discovering new
forms of moral hazard (Holmström, 1982), creating holdups (Williamson,
1996), and inventing new ways of engaging in rent-seeking activities
(Baumol, 1990; Holcombe, 2002) are examples of destructive entrepreneurship.
“Productive entrepreneurship” refers to the creation or discovery
of new attributes leading to an increase in firm value. For example, a
franchisee may discover new local tastes that in turn may form the basis for
new products for the entire chain; an employee may figure out better uses
of production assets and communicate this to the TQM team of which he
is a member; a CEO may formulate a new business concept; etc. In the
following, we use this distinction to sketch an entrepreneurial approach to
internal organization. Note that we here use the term “entrepreneurship”
more broadly than before, referring not only to decisions made by resource
owners (entrepreneurship in the strict sense), but also to decisions made
by employees, acting as proxy decision makers for the resource owners.
Foss, Foss, and Klein (2007) refer to employee exercise of this discretion

86
as derived judgment, meaning judgment that is derived from the owner’s
original judgment.
FUNDAMENTAL TRADEOFFS IN INTERNAL ORGANIZATION. e first such
problem concerns the control of destructive entrepreneurial activities. For
example, firms may delimit employees’ use of telephone and Internet
services by closely specifying their use rights over the relevant assets,
instructing them to act in a proper manner towards customers and to
exercise care when operating the firm’s equipment, and the like. However,
firms are unlikely to succeed entirely in their attempt to curb such
activities. Monitoring employees may be costly; moreover, employees
may creatively circumvent constraints, for example by inventing ways
to hide their behavior. Although firms may know that such destructive
entrepreneurship takes place, they may prefer not to try to constrain it
further. is is because the various constraints that firms impose on
employees (or, more generally, that contracting partners impose on each
other) to curb destructive entrepreneurship may have the unwanted side
effect that productive entrepreneurship is stifled (see Kirzner, 1985a).
More generally, imposing (too many) constraints on employees may
reduce their propensity to create or discover new attributes of productive
assets. At any rate, many firms increasingly appear to operate on the
presumption that beneficial effects may be produced by reducing constraints
on employees in various dimensions. For example, firms such
as 3M give research employees time to use however they wish, in the
hope of stimulating serendipitous discoveries. Many consulting firms do
something similar. More generally, industrial firms have long known that
employees with many decision rights—researchers, for example—must be
monitored and constrained in different, and typically much looser, ways
than those employees charged only with routine tasks. More broadly,
the increasing emphasis on “empowerment” during recent decades reflects
a realization that employees derive a benefit from controlling aspects of
their job situation. Moreover, the total quality movement emphasizes that
delegating various rights to employees motivates them to find new ways to
increase the mean and reduce the variance of quality (Jensen and Wruck,
1994). To the extent that such activities increase firm value, they represent
productive entrepreneurship.

87
Stimulating the productive creation and discovery of new attributes
by relaxing constraints on employees results in principal–agent relationships
that are less completely specified. is is not simply a matter of
delegation, or co-locating decision rights and specific knowledge (Jensen
and Meckling, 1992), but also giving agents opportunities to exercise their
own, often far-reaching, judgments. However, as we have seen, this also
permits potentially destructive entrepreneurship. Managing the tradeoff
between productive and destructive entrepreneurship thus becomes a critical
management task.
CHOOSING EFFICIENT TRADEOFFS. In this context, asset ownership is important
because it gives entrepreneurs the right to define contractual constraints,
that is, to choose their own preferred tradeoffs. Briefly stated,
ownership allows the employer-entrepreneur’s preferred degree of contractual
incompleteness and therefore a certain combination of productive and
destructive entrepreneurship to be implemented at low cost. is function
of ownership is particularly important in a dynamic market process, the
kind stressed by Knight (in the later chapters of Knight, 1921) and the
Austrians. In such a context, an ongoing process of judgmental decision
making requires contractual constraints to address the changing tradeoffs
between productive and destructive entrepreneurship inside the firm. e
power conferred by ownership allows the employer-entrepreneur to do this
at low cost. 17
Concluding Discussion
is chapter emphasizes the importance of capital heterogeneity for theories
of entrepreneurship and the firm. If capital were homogeneous, the
entrepreneurial act would be trivial. Many, if not most, of the interesting
problems of economic organization would disappear. is implies that
the theory of capital should be an integral part of theories of entrepreneurship
and economic organization. It also suggests extending the Austrian
emphasis on entrepreneurship in markets to entrepreneurship in firms. 18
17 For a fuller analysis of this point see Foss and Foss (2002).
18 e alert reader will notice that while we enthusiastically endorse Kirzner’s contributions
to the Austrian theory of capital, our own conception of entrepreneurship differs
substantially from his. Chapter 5 below explores this distinction in greater detail.

88
However, the concept of capital heterogeneity does more than simply
establish the necessary conditions for entrepreneurship and the typical
problems of economic organization. Taking fuller account of heterogeneous
capital, as developed by the Austrian school, reveals exchange problems
(i.e. transaction costs) that are relevant to economic organization
but neglected in mainstream theories of the firm. 19 In a setting with
heterogeneous capital and uncertainty, the process of entrepreneurial experimentation
has distinct implications for economic organization. As we
have argued, the process of experimenting with heterogeneous capital may
be best organized within a firm, helping to explain why firms emerge. Similarly,
experiments with heterogeneous capital assets may underlie much
of the observed dynamics of the boundaries of firms. us, it is not a
priori known whether capital assets controlled by potential takeover target
will be a good fit with the firm’s assets; this has to be tried out in an
experimental fashion. Finally, we have argued that internal organization
is also illuminated by a focus on judgment, heterogeneous capital, and
experimentation.
To be sure, our analysis so far is preliminary and incomplete. We
have concentrated on exploring the links between Austrian economics and
conventional approaches to economic organization. 20 Because we offer
here an exploratory, suggestive treatment, we have not described specific
causal mechanisms and have not put any explicit, testable propositions on
the table.
However, our approach is potentially rich in explanatory power. For
example, because entrepreneurial judgment requires resource ownership,
the theory of employment—the contractual relations between the entrepreneurs
and those they hire to help them execute their plans—is ultimately
a theory of delegation. Judgment, as the ultimate decision-making
factor of production (in Grossman and Hart’s terminology, the residual
rights of control) cannot be delegated, by definition. But many other
proximate decision rights can, and frequently are, delegated to employees.
Operationalizing this insight, and deriving testable implications from
it, can be done by identifying the circumstances under which particular
19 In contrast, our emphasis on understanding economic organization in a dynamic
context has obvious parallels to Langlois’s (1992) notion of “dynamic transaction costs.”
20 See Shook, Priem, and McGee (2003) for ideas on empirical research on the behavioral
aspects of entrepreneurial judgment.

89
decision rights (what we may call derived judgment) can be delegated to
particular individuals. ese circumstances can be described by characteristics
of the business environment (technology, markets, regulation),
employees’ human capital (what Schultz, 1975, calls “the ability to deal
with disequilibria”), and aspects of firm strategy. Consider the following
applications.
DECENTRALIZATION. One approach to delegation is to build on the literature
on optimal decentralization, such as Jensen and Meckling’s (1992) important
(and, in our judgment, under-appreciated) application of Hayek’s
and Polanyi’s theory of knowledge to internal organization. Jensen and
Meckling identify some benefits and costs of decentralizing decision rights
to lower levels of an organization. e primary benefit is more effective
use of specific (local, tacit) knowledge, while costs include potential agency
problems and less effective use of central information. Decentralization, in
Jensen and Meckling’s terminology, achieves the co-location of knowledge
and decision rights. Employees who are not owners, however, exercise
only derived judgment, no matter how many decision rights they hold.
Optimal decentralization can thus be interpreted in terms of the tradeoff
between knowledge and judgment. Assigning decision rights to employees
co-locates specific knowledge and derived judgment, while judgment itself
remains in the hands of owners. e decision to decentralize therefore
depends not only on the importance of specific knowledge, but on the
“wedge” between ultimate and derived judgment. Where environmental
uncertainty is high, this wedge may be sufficiently large that decentralization
reduces firm value, even controlling for the importance of specific
knowledge.
OCCUPATIONAL CHOICE. Another application relates to the literature on
occupational choice. Many studies of entrepreneurship treat entrepreneurship
as an occupation (i.e. self-employment), rather than a function, as we
treat it here (see, for example, Hamilton, 2000). What is the correlation
between self-employment and judgment? Self-employed individuals who
finance their ventures with debt or personal savings are surely acting as
Knightian entrepreneurs. If a new venture is financed with equity, then
in our framework it is the financier—the venture capitalist or angel investor,
for example—who is bearing the relevant uncertainty and therefore

90
performing the entrepreneurial function, not the firm founder (except to
the extent that the founder’s compensation is a function of the outcome
of the venture). We are unaware of existing empirical work relating selfemployment
to the entrepreneurial function, though such work should
be important in understanding the role of self-employment in generating
economic growth.
CONTRACT DESIGN. Moreover, our approach to the entrepreneurial function
has implications for contract design. If we think of judgment as filling
in the gaps of incomplete contracts, then the more complete the contract,
the fewer circumstances in which “ultimate judgment” must be exercised,
and hence the more decision rights that can be delegated. is implies
an inverse relationship between contractual completeness and monitoring
costs. While several TCE papers examine the determinants of completeness
(Crocker and Masten, 1991; Crocker and Reynolds, 1993; Saussier,
2000), they generally focus on asset specificity, not monitoring costs, as
the independent variable.
ORGANIZATIONAL LEARNING. Our approach also has implications for organizational
learning. If entrepreneurship, and hence economic organization,
is the act of arranging heterogeneous capital resources, then it is
important to understand how individuals and teams learn to do this successfully.
Mayer and Argyres (2004) show that contracting parties do
not necessarily anticipate contractual hazards, and design arrangements
to mitigate them, as TCE predicts; rather, contracting parties must often
experience maladaptation to adjust to it. It is thus important to understand
not only efficient contracting, but the process of learning to contract efficiently.
In our framework, contracting—an exchange of legal rights and
responsibilities governing the exchange of property titles—is part of the
process of entrepreneurial experimentation. Just as asset attributes must
be created or discovered over time, the efficient contractual arrangements
governing asset uses must be created or discovered over time, through
experimentation. Conceiving the problem this way calls for a theory of
learning to organize heterogeneous capital.
More generally, we hope the analysis here inspires researchers to investigate
the Austrian approach to capital and to explore its applications
not only to the theory of entrepreneurship, but also to other aspects of

91
economic organization and management. Management scholars are beginning
to recognize the value of Austrian economics beyond generalities
about the “market process” or “alertness.” (Lachmann’s capital theory, for
example, features prominently in Chiles and Zarankin 2005; Chiles, Bluedorn,
and Gupta 2007; Lewin 2005; Lewin and Phelan 2002.) We hope
that researchers seeking to incorporate the concept of entrepreneurship
into organization, strategy, and the theory of the firm will consider the
Austrian notion of capital heterogeneity as a possible link between entrepreneurship
and economic organization.

CHAPTER 5
Opportunity Discovery and Entrepreneurial Action †
Entrepreneurship is one of the fastest growing fields within economics,
management, finance, and even law. Surprisingly, however, while the
entrepreneur is fundamentally an economic agent—the driving force of the
market, in Mises’s (1949, p. 249) phrase—modern theories of economic
organization and strategy maintain an ambivalent relationship with entrepreneurship.
It is widely recognized that entrepreneurship is somehow
important, but there is little consensus about how the entrepreneurial role
should be modeled and incorporated into economics and strategy. Indeed,
the most important works in the economic literature on entrepreneurship—Schumpeter’s
account of innovation, Knight’s theory of profit, and
Kirzner’s analysis of entrepreneurial discovery—are viewed as interesting,
but idiosyncratic, insights that do not easily generalize to other contexts
and problems.
e awkward relationship between mainstream economics and entrepreneurship
makes sense in the context of the development of the neoclassical
theory of production and the firm. e increasingly formalized
treatment of markets, notably in the form of general equilibrium theory,
† Published originally as “Opportunity Discovery, Entrepreneurial Action, and Economic
Organization” in Strategic Entrepreneurship Journal 2, no. 3 (2008): 175–90.
93

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not only made firms increasingly passive, it also made the model of the firm
increasingly stylized and anonymous, doing away with those dynamic aspects
of markets that are most closely related to entrepreneurship (O’Brien,
1984). In particular, the development of what came to be known as the
production-function view (Williamson, 1985; Langlois and Foss, 1999)—
roughly, the firm as it is presented in intermediate microeconomics textbooks
with its fully transparent production possibility sets—was a deathblow
to the economic theory of entrepreneurship. If any firm can do
what any other firm does (Demsetz, 1988b), if all firms are always on
their production possibility frontiers, and if firms always make optimal
choices of input combinations and output levels, then there is nothing
for the entrepreneur to do. Even in more advanced models of asymmetric
production functions, hidden characteristics, and strategic interaction,
firms or agents are modeled as behaving according to fixed rules subject
to formalization by the analyst. e entrepreneur makes an occasional
appearance in business history and in Schumpeterian models of innovation
and technical change, but is largely absent from contemporary economic
theory.
One exception is the Austrian School, which has given the entrepreneur
a central role in the economy, at least since the proto-Austrian contribution
of Richard Cantillon (1755). Key figures in the Austrian School,
such as Carl Menger (1871), Eugen von Böhm-Bawerk (1889), Ludwig
von Mises (1949), and Murray Rothbard (1962) all emphasized the entrepreneur
in their causal-realistic analysis of economic organization and economic
change. More recently, the Austrian economist Israel Kirzner has
popularized the notion of entrepreneurship as discovery or alertness to
profit opportunities. Kirzner’s interpretation of Mises has been highly influential,
not only within the Austrian School, but also in the opportunitydiscovery
or opportunity-recognition branch of entrepreneurship literature
(Shane and Venkataraman, 2000; Gaglio and Katz, 2001; Shane, 2003).
However, as described below, the opportunity-discovery framework
is problematic as a foundation for applied entrepreneurship research. Its
central concept, the opportunity, was intended by theorists such as Kirzner
to be used instrumentally, or metaphorically, as a means of explaining
the tendency of markets to equilibrate, and not meant to be treated literally
as the object of analysis. I argue that entrepreneurship can be more
thoroughly grounded and more closely linked to theories of economic

95
organization and strategy by adopting the Cantillon–Knight–Mises understanding
of entrepreneurship as judgment, along with the Austrian School’s
subjectivist account of capital heterogeneity. e judgment approach emphasizes
that profit opportunities do not exist, objectively, when decisions
are made, because the result of action cannot be known with certainty.
Opportunities are essentially subjective phenomena (Foss, Klein, Kor, and
Mahoney, 2008). As such, opportunities are neither discovered nor created
(Alvarez and Barney, 2007), but imagined. ey exist, in other words,
only in the minds of decision-makers. Moreover, the essentially subjective
character of profit opportunities poses special challenges for applied
research on the cognitive psychological aspects of discovery. Rather, I
argue, opportunities can be treated as a latent concept underlying the real
phenomenon of interest, namely entrepreneurial action.
I begin by distinguishing among occupational, structural, and functional
approaches to entrepreneurship and explaining two influential interpretations
of the entrepreneurial function—discovery and judgment. I
turn next to the contemporary literature on opportunity identification,
arguing that this literature misinterprets Kirzner’s instrumental use of the
discovery metaphor and mistakenly makes opportunities the unit of analysis.
Instead, I describe an alternative approach in which investment is
the unit of analysis, and link this approach to the theory of heterogeneous
capital theory. I close with some applications to organizational form and
entrepreneurial teams.
Entrepreneurship: Occupational, Structural, and Functional
Perspectives
To organize the various strands of entrepreneurship literature, it is useful
to distinguish among occupational, structural, and functional perspectives.
Occupational theories define entrepreneurship as self-employment
and treat the individual as the unit of analysis, describing the characteristics
of individuals who start their own businesses and explaining the choice
between employment and self-employment (Kihlstrom and Laffont, 1979;
Shaver and Scott, 1991; Hamilton, 2000; Parker, 2004; Lazear, 2004,
2005). e labor economics literature on occupational choice, along with
psychological literature on the personal characteristics of self-employed
individuals, fits in this category. For example, McGrath and MacMillan

96
(2000) argue that particular individuals have an “entrepreneurial mindset”
that enables and encourages them to find opportunities overlooked or
ignored by others (and that this mindset is developed through experience,
rather than formal instruction). Structural approaches treat the firm or
industry as the unit of analysis, defining the “entrepreneurial firm” as a new
or small firm. e literatures on industry dynamics, firm growth, clusters,
and networks have a structural concept of entrepreneurship in mind (Aldrich,
1990; Acs and Audretsch, 1990; Audretsch, Keilbach, and Lehmann,
2005). Indeed, the idea that one firm, industry, or economy can be more
“entrepreneurial” than another suggests that entrepreneurship is associated
with a particular market structure (i.e., lots of small or young firms).
By contrast, the classic contributions to the economic theory of entrepreneurship
from Schumpeter, Knight, Mises, Kirzner, and others model
entrepreneurship as a function, activity, or process, not an employment
category or market structure. e entrepreneurial function has been characterized
in various ways: judgment (Cantillon, 1755; Knight, 1921; Casson,
1982; Langlois and Cosgel, 1993; Foss and Klein, 2005), innovation
(Schumpeter, 1911), adaptation (Schultz, 1975, 1980), alertness (Kirzner,
1973, 1979, 1992), and coordination (Witt, 1998, 2003). In each case,
these functional concepts of entrepreneurship are largely independent of
occupational and structural concepts. e entrepreneurial function can be
manifested in large and small firms, in old and new firms, by individuals or
teams, across a variety of occupational categories, and so on. By focusing
too narrowly on self-employment and start-up companies, the contemporary
literature may be understating the role of entrepreneurship in the
economy and business organizations.
Kirzner’s (1973; 1979; 1992) concept of entrepreneurship as “alertness”
to profit opportunities is one of the most influential functional approaches.
e simplest case of alertness is that of the arbitrageur who
discovers a discrepancy in present prices that can be exploited for financial
gain. In a more typical case, the entrepreneur is alert to a new product or
a superior production process and steps in to fill this market gap before
others. Success, in this view, comes not from following a well-specified
maximization problem, but from having some insight that no one else
has, a process that cannot be modeled as an optimization problem. 1 As
1 Kirzner is careful to distinguish alertness from systematic search, as in Stigler’s (1961;
1962) analysis of searching for bargains or for jobs. A nice example is provided by Ricketts

97
discussed in chapter 2 above, because Kirzner’s entrepreneurs perform only
a discovery function, rather than an investment function, they do not own
capital; they need only be alert to profit opportunities. ey own no assets,
they bear no uncertainty and, hence, they cannot earn losses. e worst
that can happen to an entrepreneur is the failure to discover an existing
profit opportunity. For these reasons, the link between Kirznerian entrepreneurship
and other branches of economic analysis, such as industrial
organization, innovation, and the theory of the firm, is weak. Hence,
Kirzner’s concept has not generated a large body of applications. 2
An alternative account treats entrepreneurship as judgmental decision
making under conditions of uncertainty. Judgment refers primarily to
business when the range of possible future outcomes, let alone the likelihood
of individual outcomes, is generally unknown (what Knight terms
uncertainty, rather than mere probabilistic risk). is view finds expression
in the earliest known discussion of entrepreneurship—that found in
Richard Cantillon’s Essai sur la nature de commerce en general (1755). Cantillon
argues that all market participants, with the exception of landowners
and the nobility, can be classified as either entrepreneurs or wage earners:
Entrepreneurs work for uncertain wages, so to speak, and all others
for certain wages until they have them, although their functions and
their rank are very disproportionate. e General who has a salary,
the Courtier who has a pension, and the Domestic who has wages,
are in the latter class. All the others are Entrepreneurs, whether they
establish themselves with a capital to carry on their enterprise, or are
Entrepreneurs of their own work without any capital, and they may
be considered as living subject to uncertainty; even Beggars and
Robbers are Entrepreneurs of this class (Cantillon, 1755, p. 54).
(1987, p. 58): “Stigler’s searcher decides how much time it is worth spending rummaging
through dusty attics and untidy drawers looking for a sketch which (the family recalls) Aunt
Enid thought might be by Lautrec. Kirzner’s entrepreneur enters a house and glances lazily
at the pictures which have been hanging in the same place for years. ‘Isn’t that a Lautrec
on the wall?’ ”
2 Exceptions include Ekelund and Saurman (1988), Harper (1995), Sautet (2001) and
Holcombe (2002). Kirzner (1973, pp. 39–40) concedes that in a world of uncertainty,
resource owners exercise entrepreneurial judgment in allocating their resources to particular
uses. But he goes on (1973, pp. 40–43) to introduce the analytical device of “pure
entrepreneurship,” the act of discovery or alertness to profit opportunities by those with
no resources under their control, and claims that this function, rather than uncertaintybearing,
is the “driving force” behind the market economy.

98
Judgment is distinct from boldness, innovation, alertness, and leadership.
Judgment must be exercised in mundane circumstances, for ongoing
operations as well as new ventures. Alertness is the ability to react to existing
opportunities, while judgment refers to beliefs about new opportunities. 3
ose who specialize in judgmental decision making may be dynamic,
charismatic leaders, but they need not possess these traits. In short, in
this view, decision making under uncertainty is entrepreneurial, whether
it involves imagination, creativity, leadership, and related factors or not.
Knight introduces judgment to link profit and the firm to uncertainty.
Entrepreneurship represents judgment that cannot be assessed in terms
of its marginal product and which cannot, accordingly, be paid a wage
(Knight, 1921, p. 311). In other words, there is no market for the judgment
that entrepreneurs rely on and, therefore, exercising judgment requires
the person with judgment to start a firm. Judgment, thus, implies
asset ownership, for judgmental decision making is ultimately decision
making about the employment of resources. An entrepreneur without capital
goods is, in Knight’s sense, no entrepreneur (Foss and Klein, 2005). 4
Entrepreneurship as uncertainty bearing is also important for Mises’s
3 In Kirzner’s treatment, entrepreneurship is characterized as “a responding agency. I
view the entrepreneur not as a source of innovative ideas ex nihilo, but as being alert
to the opportunities that exist already and are waiting to be noticed” (Kirzner, 1973,
p. 74). Of course, as Kirzner (1985b, pp. 54–59) himself emphasizes, the actions of
entrepreneurs in the present affect the constellation of possible profit opportunities in the
future. “[Alertness] does not consist merely in seeing the unfolding of the tapestry of the
future in the sense of seeing a preordained flow of events. Alertness must, importantly,
embrace the awareness of the ways the human agent can, by imaginative, bold leaps of faith,
and determination, in fact create the future for which his present acts are created” (Kirzner,
1985b, p. 56). However, Kirzner (1985b, p. 57) continues, the only opportunities that
matter for equilibration are those that do, in fact, “bear some realistic resemblance to the
future as it will be realized.”
4 It is useful here to distinguish between broad and narrow notions of (Knightian) entrepreneurship.
All human action involves judgment, and in an uncertain world, all action
places some assets at risk (at minimum, the opportunity cost of the actor’s time). In Mises’s
terminology, human action is the purposeful employment of means to bring about desired
ends, which may or may not be realized. In this sense, we are all entrepreneurs, every
day. Of course, this broad concept of entrepreneurship is not particularly operational, or
empirically important. Economics and organization theorists, therefore, tend to focus on
a narrower concept of entrepreneurship, namely the actions of the businessperson—the
investment of tangible resources in pursuit of commercial gain. In the discussion that
follows, I focus on this narrower, commercial notion of entrepreneurship.

99
theory of profit and loss—a cornerstone of his well-known critique of
economic planning under socialism. Mises begins with the marginal productivity
theory of distribution developed by his Austrian predecessors.
In the marginal productivity theory, laborers earn wages, capitalists earn
interest, and owners of specific factors earn rents. Any excess (deficit) of a
firm’s realized receipts over these factor payments constitutes profit (loss).
Profit and loss, therefore, are returns to entrepreneurship. In a hypothetical
equilibrium without uncertainty (what Mises calls the evenly rotating
economy), capitalists would still earn interest as a reward for lending, but
there would be no profit or loss.
Entrepreneurs, in Mises’s understanding of the market, make their
production plans based on the current prices of factors of production and
the anticipated future prices of consumer goods. What Mises calls “economic
calculation” is the comparison of these anticipated future receipts
with present outlays, all expressed in common monetary units. Under
socialism, the absence of factor markets and the consequent lack of factor
prices renders economic calculation—and hence rational economic planning—impossible.
Mises’s point is that a socialist economy may assign individuals
to be workers, managers, technicians, inventors, and the like, but
it cannot, by definition, have entrepreneurs, because there are no money
profits and losses. Entrepreneurship, and not labor, management or technological
expertise, is the crucial element of the market economy. As Mises
puts it, directors of socialist enterprises may be allowed to play market—to
make capital investment decisions as if they were allocating scarce capital
across activities in an economizing way. But entrepreneurs cannot be asked
to “play speculation and investment” (Mises, 1949, p. 705). Without
entrepreneurship, a complex, dynamic economy cannot allocate resources
to their highest value use.
Entrepreneurship as Opportunity Identification
While Schumpeter, Kirzner, Cantillon, Knight, and Mises are frequently
cited in the contemporary entrepreneurship literature in economics and
management (Schultz, by contrast, is rarely cited), much of this literature
takes, implicitly, an occupational or structural approach to entrepreneurship.
Any relationship to the classic functional contributions is inspirational,
not substantive.

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e most important exception is the literature in management and organization
theory on opportunity discovery or opportunity identification,
or what Shane (2003) calls the “individual–opportunity nexus.” Opportunity
identification involves not only technical skills like financial analysis
and market research, but also less tangible forms of creativity, team building,
problem solving, and leadership (Long and McMullan, 1984; Hills,
Lumpkin, and Singh, 1997; Hindle, 2004). While value can, of course,
be created not only by starting new activities, but also by improving the
operation of existing activities, research in opportunity identification tends
to emphasize new activities. ese could include creating a new firm or
starting a new business arrangement, introducing a new product or service,
or developing a new method of production. As summarized by Shane
(2003, pp. 4–5):
Entrepreneurship is an activity that involves the discovery, evaluation,
and exploitation of opportunities to introduce new goods
and services, ways of organizing, markets, process, and raw materials
through organizing efforts that previously had not existed
(Venkataraman, 1997; Shane and Venkataraman, 2000). Given
this definition, the academic field of entrepreneurship incorporates,
in its domain, explanations for why, when, and how entrepreneurial
opportunities exist; the sources of those opportunities and
the forms that they take; the processes of opportunity discovery
and evaluation; the acquisition of resources for the exploitation
of these opportunities; the act of opportunity exploitation; why,
when, and how some individuals and not others discover, evaluate,
gather resources for, and exploit opportunities; the strategies used
to pursue opportunities; and the organizing efforts to exploit them
(Shane and Venkataraman, 2000).
is conception is admirably broad, incorporating not only opportunity
discovery, but also the processes by which opportunities are pursued
and exploited. What unifies these varied aspects of the entrepreneurial
function is the concept of the opportunity. e discovery and (potential)
exploitation of opportunities is proposed as the unit of analysis for entrepreneurship
research. But what exactly are opportunities? How are they
best characterized? How much explicit characterization is necessary for
applied research in entrepreneurial organization and strategy?

101
Opportunities: Objective or Subjective?
Shane and Venkataraman (2000, p. 220) define entrepreneurial opportunities
as “those situations in which new goods, services, raw materials,
and organizing methods can be introduced and sold at greater than
their cost of production.” ese opportunities are treated as objective phenomena,
though their existence is not known by all agents. Shane and
Venkataraman also distinguish entrepreneurial opportunities from profit
opportunities more generally. While the latter reflect opportunities to create
value by enhancing the efficiency of producing existing goods, services,
and processes, the former includes value creation through “the very perception
of the means-ends framework” itself (Kirzner, 1973, p. 33). Shane
and Venkataraman seem to have in mind the distinction between activities
that can be modeled as solutions to well-specified optimization problems—what
Kirzner (1973) calls “Robbinsian maximizing”—and those
for which no existing model, or decision rule, is available.
However, Shane and Venkataraman appear to misunderstand Kirzner
(and the Austrians more generally) on this point. In a world of Knightian
uncertainty, all profit opportunities involve decisions for which no wellspecified
maximization problem is available. Kirzner does not mean that
some economic decisions really are the result of Robbinsian maximizing,
while others reflect discovery. Instead, Kirzner is simply contrasting two
methodological constructions for the analysis of human action.
More generally, the opportunity identification literature seeks to build
a positive research program by operationalizing the concept of alertness.
How is alertness manifested in action? How do we recognize it empirically?
Can we distinguish discovery from systematic search? As summarized by
Gaglio and Katz (2001, p. 96):
Almost all of the initial empirical investigations of alertness have
focused on the means by which an individual might literally notice
without search. For example, Kaish and Gilad (1991) interpret this
as having an aptitude to position oneself in the flow of information
so that the probability of encountering opportunities without a deliberate
search for a specific opportunity is maximized. erefore,
in their operational measures of alertness, they asked founders to
recall: (a) the amount of time and effort exerted in generating
an information flow; (b) the selection of information sources for

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generating an information flow; and (c) the cues inherent in information
that signal the presence of an opportunity. From this data
the authors deduced: (d) the quantity of information in the flow
and (e) the breadth and diversity of information in the flow.
eir results conform to expectations in some ways but also
reveal some unexpected patterns. Compared to the sample of corporate
executives, the sample of new venture founders do appear
to spend more time generating an information flow and do seem
more likely to use unconventional sources of information. Interestingly,
the founders do seem more attentive to risk cues rather
than to market potential cues. However, the data also reveal that
only inexperienced or unsuccessful founders engage in such intense
information collection efforts. Successful founders actually behave
more like the sample of corporate executives. Cooper et al. (1995)
found a similar pattern of results in their survey of 1100 firms
although Busenitz (1996), in an altered replication of Kaish and
Gilad’s survey, did not. Indeed Busenitz found few significant differences
between corporate managers and new venture founders. In
addition, validity checks of the survey measures yielded low reliability
scores, which led the author to conclude that future research in
alertness required improved theoretical and operational precision.
is positive research program misses, however, the point of Kirzner’s
metaphor of entrepreneurial alertness: namely, that it is only a metaphor.
Kirzner’s aim is not to characterize entrepreneurship per se, but to explain
the tendency for markets to clear. In the Kirznerian system, opportunities
are (exogenous) arbitrage opportunities and nothing more. Entrepreneurship
itself serves a purely instrumental function; it is the means by which
Kirzner explains market clearing. Of course, arbitrage opportunities cannot
exist in a perfectly competitive general-equilibrium model, so Kirzner’s
framework assumes the presence of competitive imperfections, to use the
language of strategic factor markets (Barney, 1986; Alvarez and Barney,
2004). Beyond specifying general disequilibrium conditions, however,
Kirzner offers no theory of how opportunities come to be identified, who
identifies them, and so on; identification itself is a black box. e claim
is simply that outside the Arrow–Debreu world, in which all knowledge is
effectively parameterized, opportunities for disequilibrium profit exist and
tend to be discovered and exploited. In short, what Kirzner calls “entrepreneurial
discovery” is simply that which causes markets to equilibrate. 5
5 e foregoing description applies primarily to what Kirzner calls the “pure entre-

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Contemporary entrepreneurship scholars, considering whether opportunities
are objective or subjective (McMullen and Shepherd, 2006; Companys
and McMullen, 2007), note that Kirzner tends to treat them as
objective. Again, this is true, but misses the point. Kirzner is not making
an ontological claim about the nature of profit opportunities per se—not
claiming, in other words, that opportunities are, in some fundamental
sense, objective—but merely using the concept of objective, exogenously
given, but not yet discovered opportunities as a device for explaining the
tendency of markets to clear. 6
e Knightian perspective also treats entrepreneurship as an instrumental
construct, used here to decompose business income into two constituent
elements—interest and profit. Interest is a reward for forgoing
present consumption, is determined by the relative time preferences of
borrowers and lenders, and would exist even in a world of certainty. Profit,
by contrast, is a reward for anticipating the uncertain future more accurately
than others (e.g., purchasing factors of production at market prices
below the eventual selling price of the product), and exists only in a world
of true uncertainty. In such a world, given that production takes time,
entrepreneurs will earn either profits or losses based on the differences
between factor prices paid and product prices received.
For Knight, in other words, opportunities do not exist, just waiting to
be discovered (and hence, by definition, exploited). Rather, entrepreneurs
invest resources based on their expectations of future consumer demands
and market conditions, investments that may or may not yield positive
returns. Here the focus is not on opportunities, but on investment and
uncertainty. Expectations about the future are inherently subjective and,
under conditions of uncertainty rather than risk, constitute judgments
that are not themselves modelable. Put differently, subjectivism implies
preneur” (see footnote 2 above). As he explains, flesh and blood entrepreneurs do not
correspond exactly to this ideal type (they can simultaneously be laborers, capitalists,
consumers, etc.)—and they do more than simply discover costless profit opportunities.
However, in Kirzner’s framework, the attributes of real-world entrepreneurs defy systematic
categorization.
6 Incidentally, the occupational choice literature cited above treats opportunities, implicitly
or explicitly, as objective. Agents are assumed to compare the expected benefits
of employment and self-employment, meaning that the set of possible entrepreneurial
outcomes must be fixed, and the probability weights assigned to individual outcomes
known in advance.

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that opportunities do not exist in an objective sense. Hence, a research
program based on formalizing and studying empirically the cognitive or
psychological processes leading individuals to discover opportunities captures
only a limited aspect of the entrepreneurial process. Opportunities
for entrepreneurial gain are, thus, inherently subjective—they do not exist
until profits are realized. Entrepreneurship research may be able to realize
higher marginal returns by focusing on entrepreneurial action, rather than
its presumed antecedents. 7
Alvarez and Barney (2007) argue that entrepreneurial objectives, characteristics,
and decision making differ systematically, depending on whether
opportunities are modeled as discovered or created. In the “discovery
approach,” for example, entrepreneurial actions are responses to exogenous
shocks, while in the “creation approach,” such actions are endogenous.
Discovery entrepreneurs focus on predicting systematic risks, formulating
complete and stable strategies, and procuring capital from external sources.
Creation entrepreneurs, by contrast, appreciate iterative, inductive, incremental
decision making, are comfortable with emergent and flexible
strategies, and tend to rely on internal finance. 8
e approach proposed here is close to Alvarez and Barney’s creation
approach, but differs in that it places greater emphasis on the ex post processes
of resource assembly and personnel management rather than the ex
ante processes of cognition, expectations formation, and business planning.
Moreover, Alvarez and Barney write as if “discovery settings” and
“creation settings” are actual business environments within which entrepreneurs
operate. Some entrepreneurs really do discover exogenously created
profit opportunities, while others have to work creatively to establish
them. As I read Knight and Kirzner, by contrast, both the discovery
and creation perspectives are purely metaphorical concepts (useful for the
economist or management theorist), not frameworks for entrepreneurial
7 Here I follow Gul and Pesendorfer’s (2005, p. 1) more general critique of neuroeconomìcs,
namely that cognitive psychology and economics “address different questions,
utilize different abstractions, and address different types of empirical evidence,” meaning
that the two disciplines are in essentially different, though potentially complementary, domains.
In other words, understanding the cognitive processes underlying entrepreneurial
behavior may be interesting and important, but not necessary for the economic analysis of
the behavior itself.
8 Miller (2007) distinguishes further between opportunity recognition, opportunity
discovery, and opportunity creation.

105
decision making itself. is suggests that opportunities are best characterized
neither as discovered nor created, but imagined. e creation
metaphor implies that profit opportunities, once the entrepreneur has conceived
or established them, come into being objectively, like a work of art.
Creation implies that something is created. ere is no uncertainty about
its existence or characteristics (though, of course, its market value may not
be known until later). By contrast, the concept of opportunity imagination
emphasizes that gains (and losses) do not come into being objectively until
entrepreneurial action is complete (i.e., until final goods and services have
been produced and sold). 9
Moreover, explaining entrepreneurial loss is awkward using both discovery
and creation language. In Kirzner’s formulation, for example, the
worst that can happen to an entrepreneur is the failure to discover an existing
profit opportunity. Entrepreneurs either earn profits or break even,
but it is unclear how they suffer losses. Kirzner (1997) claims that entrepreneurs
can earn losses when they misread market conditions. “Entrepreneurial
boldness and imagination can lead to pure entrepreneurial losses
as well as to pure profit. Mistaken actions by entrepreneurs mean that
they have misread the market, possibly pushing price and output constellations
in directions not equilibrative” Kirzner (1997, p. 72). But even
this formulation makes it clear that it is mistaken actions—not mistaken
discoveries—that lead to loss. Misreading market conditions leads to losses
only if the entrepreneur has invested resources in a project based on this
misreading. It is the failure to anticipate future market conditions correctly
that causes the loss. It seems obscure to describe this as erroneous
discovery, rather than unsuccessful uncertainty bearing. 10
Likewise, realized entrepreneurial losses do not fit naturally within a
9 e concept of “opportunity imagination” calls to mind Boulding’s (1956, p. 15)
notion of “image,” defined as “the sum of what we think we know and what makes
us behave the way we do.” Human action, in Boulding’s framework, is a response to
the actor’s (subjective) image of reality. is does not mean that images are completely
detached from reality, but that reality is altered, or interpreted, by the actor’s subjective
beliefs. Penrose’s (1959) concept, of the firm’s subjective opportunity set also reflects
entrepreneurial imagination in this sense (Kor, Mahoney, and Michael, 2007).
10 In his defense, Kirzner’s (1997) remarks appear in the context of defending the
equilibrating tendency of the market, against the Walrasian picture of instantaneous market
adjustment. Still, the defense could perhaps be made equally well without reference to the
discovery metaphor.

106
creation framework. Alvarez and Barney (2007) emphasize that “creation
entrepreneurs” do take into account potential losses, the “acceptable losses”
described by Sarasvathy (2001). “[A]n entrepreneur engages in entrepreneurial
actions when the total losses that can be created by such activities
are not too large” (Alvarez and Barney, 2007, p. 19). However, when
those losses are realized, it seems more straightforward to think in terms of
mistaken beliefs about the future—expected prices and sales revenues that
did not, in fact, materialize—than the “disappearance” of an opportunity
that was previously created. Entrepreneurs do not, in other words, create
the future, they imagine it, and their imagination can be wrong as often as
it is right. 11
Opportunities as a black box
Confusion over the nature of opportunities is increasingly recognized. As
noted by McMullen, Plummer, and Acs (2007, p. 273),
a good portion of the research to date has focused on the discovery,
exploitation, and consequences thereof without much attention to
the nature and source of opportunity itself. Although some researchers
argue that the subjective or socially constructed nature
of opportunity makes it impossible to separate opportunity from
the individual, others contend that opportunity is as an objective
construct visible to or created by the knowledgeable or attuned
entrepreneur. Either way, a set of weakly held assumptions about
the nature and sources of opportunity appear to dominate much of
the discussion in the literature.
Do we need a precise definition of opportunities to move forward? Can
one do entrepreneurship research without specifying what, exactly, entrepreneurial
opportunities are? Can we treat opportunities as a black box,
much as we treat other concepts in management, such as culture, leadership,
routines, capabilities, and the like (Abell, Felin, and Foss, 2008)?
11 To go from judgment to an explanation for market efficiency requires assumptions
about the tendency of entrepreneurial judgments to be correct. Mises’s (1951) explanation
is based on a kind of natural selection, namely that market competition rewards those
entrepreneurs whose judgments tend to be better than the judgments of their fellow
entrepreneurs. Of course, one needn’t go as far as Friedman (1953) in assuming that the
result is “optimal” behavior, in the neoclassical economist’s sense of optimality, to defend
the effectiveness of this selection process.

107
One approach is to focus not on what opportunities are, but what
opportunities do. Opportunities, in this sense, are treated as a latent construct
that is manifested in entrepreneurial action—investment, creating
new organizations, bringing products to market, and so on. A direct analogy
can be drawn to the economist’s notion of preferences. Economic
theory (with the exception of behavioral economics, discussed later) takes
agents’ preferences as a given and derives implications for choice. e
economist does not care what preferences “are,” ontologically, but simply
postulates their existence and draws inferences about their characteristics as
needed to explain particular kinds of economic behavior. Empirically, this
approach can be operationalized by treating entrepreneurship as a latent
variable in a structural-equations framework (Xue and Klein, 2010).
By treating opportunities as a latent construct, this approach sidesteps
the problem of defining opportunities as objective or subjective, real or
imagined, and so on. e formation of entrepreneurial beliefs is treated
as a potentially interesting psychological problem, but not part of the
economic analysis of entrepreneurship. It also avoids thorny questions
about whether alertness or judgment is simply luck (Demsetz, 1983), a
kind of intuition (Dane and Pratt, 2007), or something else entirely.
The unit of analysis
As explained earlier, the opportunity-creation approach proposed by Alvarez
and Barney (2007) differs in important ways from the opportunitydiscovery
approach. e creation approach treats opportunities as the
result of entrepreneurial action. Opportunities do not exist objectively,
ex ante, but are created, ex nihilo, as entrepreneurs act based on their
subjective beliefs. “Creation opportunities are social constructions that
do not exist independent of the entrepreneur’s perceptions” (Alvarez and
Barney, 2007, p. 15). In this sense, the creation approach sounds like the
imagination approach described here. Still, like the discovery approach,
the creation approach makes the opportunity the unit of analysis. How
entrepreneurs create opportunities, and how they subsequently seek to
exploit those opportunities, is the focus of the research program.
At one level, the distinction between opportunity creation and opportunity
imagination seems semantic. Both hold that entrepreneurs act
based on their beliefs about future gains and losses, rather than reacting to

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objective, exogenously given opportunities for profit. ere are some ontological
and epistemological differences, however. e creation approach
is grounded in a social constructivist view of action (Alvarez and Barney,
2007). It holds that the market itself is a social construction, and that
realized gains and losses are, in part, subjective. e imagination approach
described here is, in this sense, less subjectivist than the creation approach.
It is tied closely to Mises’s (1912; 1920) concept of monetary calculation,
in which realized gains and losses are objective and quantifiable, and used
to filter (or select) the quality of entrepreneurial expectations and beliefs.
It is compatible with a range of ontological positions, from evolutionary
realism to critical realism (Lawson, 1997; Mäki, 1996) to Misesian praxeology
(Mises, 1949).
An alternative way to frame a subjectivist approach to entrepreneurship,
emphasizing uncertainty and the passage of time, is to drop the
concept of “opportunity” altogether. If opportunities are inherently subjective
and we treat them as a black box, then the unit of analysis should
not be opportunities, but rather some action—in Knightian terms, the assembly
of resources in the present in anticipation of (uncertain) receipts in
the future. Again, the analogy with preferences in microeconomic theory
is clear: the unit of analysis in consumer theory is not preferences, but
consumption, while in neoclassical production theory, the unit of analysis
is not the production function, but some decision variable.
One could also view opportunities and actions as distinct—but complementary—aspects
of the entrepreneurial process. To use Alvarez and
Barney’s (2007) terminology, the discovery perspective treats actions as
responses to opportunities, while the creation perspective treats opportunities
as the result of action. By contrast, the perspective outlined here
treats opportunities as a superfluous concept, once action is taken into
account. Opportunities exist only as manifested in action, and are neither
its cause nor consequence of action. Hence, we can dispense with the very
notion of opportunities itself and focus on the actions that entrepreneurs
take and the results of those actions.
One way to capture the Knightian concept of entrepreneurial action is
Casson and Wadeson’s (2007) notion of “projects.” A project is a stock of
resources committed to particular activities for a specified period of time.
Project benefits are uncertain, and are realized only after projects are completed.
Casson and Wadeson (2007) model the set of potential projects as

109
a given, defining opportunities as potential projects that have not yet been
chosen. As in the discovery-process perspective, the set of opportunities
is fixed. However, as Casson and Wadeson point out, the assumption of
fixed “project possibility sets” is a modeling convenience, made necessary
by their particular theory of project selection. More generally, the use of
projects as the unit of analysis is consistent with either the discovery or creation
perspective. Focusing on projects, rather than opportunities, implies
an emphasis on the actions that generate profits and losses. It suggests that
entrepreneurship research should focus on the execution of business plans.
In this sense, entrepreneurship is closely linked to finance—not simply
“entrepreneurial finance” that studies venture funding and firm formation,
but the more general problem of project finance under (true) uncertainty.
Not only venture capital, but also public equity and debt, are entrepreneurial
instruments in this perspective. Capital budgeting is also a form of
entrepreneurial decision making. Of course contemporary finance theory
focuses primarily on equilibrium models of resource allocation under conditions
of risk, not Knightian uncertainty, so entrepreneurship theory cannot
be simply a reframing of modern finance theory. Instead, a financiers
as entrepreneurs approach treats investors not as passive suppliers of capital
to decision-making firms, but as the locus of economic decision making
itself, as economic agents who experiment with resource combinations
(chapter 3 above), develop and exploit network ties (Meyer, 2000), manage
and govern subordinates (Kaplan and Strömberg, 2003), and the like.
Entrepreneurial Action, Heterogeneous Capital, and Economic
Organization
e close relationship between the Knightian concept of entrepreneurship
as action under uncertainty and the ownership and control of resources
suggests a bridge between entrepreneurship and the mundane activities
of establishing and maintaining a business enterprise—what Witt (2003)
calls the “organizational grind.” Chapter 4 above offers an entrepreneurial
theory of the economic organization that combines the Knightian concept
of judgment and the Austrian approach to capital heterogeneity. In
Knight’s formulation, entrepreneurship represents judgment that cannot
be assessed in terms of its marginal product and which cannot, accordingly,
be paid a wage (Knight, 1921). In other words, there is no market for the

110
judgment that entrepreneurs rely on and, therefore, exercising judgment
requires the person with judgment to start a firm. Of course, judgmental
decision-makers can hire consultants, forecasters, technical experts, and so
on. However, in doing so they are exercising their own entrepreneurial
judgment. 12 us, judgment implies asset ownership, for judgmental decision
making is ultimately decision making about the employment of
resources. e entrepreneur’s role, then, is to arrange or organize the
capital goods he/she owns. As Lachmann (1956, p. 16) puts it, “We are
living in a world of unexpected change; hence capital combinations ... will
be ever changing, will be dissolved and reformed. In this activity, we find
the real function of the entrepreneur.” 13
12 In Foss, Foss, and Klein’s (2007) terminology, the entrepreneur-owner exercises “original”
judgment, while hired employees, to whom the owner delegates particular decision
rights, exercise “derived” judgment as agents of the owner. is implies that top corporate
managers, whose day-to-day decisions drive the organization of corporate resources, are
acting only as “proxy-entrepreneurs,” except to the extent that they themselves are part
owners through equity holdings.
13 Lachmann (1956) does not require the entrepreneur to own the assets he recombines;
see chapter 4 above for a more detailed argument that ownership, as residual rights of
control, is a necessary part of this entrepreneurial function. Consider also Marchal’s (1951,
pp. 550–51) explanation of the economic return to the entrepreneurial function:
[E]ntrepreneurs obtain remuneration for their activity in a very different
manner than do laborers or lenders of capital. e latter provide factors
of production which they sell to the entrepreneur at prices which they
naturally try to make as high as possible. e entrepreneur proceeds quite
otherwise; instead of selling something to the enterprise, he identifies
himself with the enterprise. Some people doubtless will say that he
provides the function of enterprise and receives as remuneration a
sum which varies according to the results. But this is a tortured way
of presenting the thing, inspired by an unhealthy desire to establish
arbitrarily asymmetry with the other factors. In reality, the entrepreneur
and the firm are one and the same. His function is to negotiate, or to
pay people for negotiating under his responsibility and in the name of
the firm, with two groups: on the one hand, with those who provide the
factors of production, in which case his problem is to pay the lowest prices
possible; on the other hand, with the buyers of the finished products,
from which it is desirable to obtain as large a total revenue as possible.
To say all this in a few words, the entrepreneur, although undeniably
providing a factor of production, perhaps the most important one in a
capitalist system, is not himself to be defined in those terms.
Marchal expresses, in strong terms, the view described in chapter 4 that entrepreneurship
is embodied in asset ownership (i.e., in the creation and operation of the firm). e

111
Chapter 4 above argues that Austrian capital theory provides a unique
foundation for an entrepreneurial theory of economic organization. Neoclassical
production theory, with its notion of capital as a permanent, homogeneous
fund of value, rather than a discrete stock of heterogeneous
capital goods, is of little help here. 14 Transaction cost, resource-based,
and property-rights approaches to the firm do incorporate notions of heterogeneous
assets, but they tend to invoke the needed specificities in an ad
hoc fashion to rationalize particular trading problems—for transaction cost
economics, asset specificity; for capabilities theories, tacit knowledge; and
so on. e Austrian approach—starting with Menger’s (1871) concepts
of higher- and lower-order goods and extending through Böhm-Bawerk’s
(1889) notion of roundaboutness, Lachmann’s (1956) theory of multiple
specificities, and Kirzner’s (1966) formulation of capital structure in
terms of subjective entrepreneurial plans—offers a solid foundation for a
judgment-based theory of entrepreneurial action.
As we saw in chapter 4, Barzel’s (1997) idea that capital goods are distinguished
by their attributes is one way to operationalize the Austrian notion
of heterogeneity. Attributes are characteristics, functions, or possible
uses of assets, as perceived by an entrepreneur. Assets are heterogeneous to
the extent that they have different, and different levels of, valued attributes.
Attributes may also vary over time, even for a particular asset. Given
Knightian uncertainty, attributes do not exist objectively, but subjectively,
in the minds of profit-seeking entrepreneurs who put these assets to use
in various lines of production. Entrepreneurship thus not only involves
deploying superior combinations of capital assets with given attributes, but
also a means of experimenting with capital assets in an attempt to create or
discover new valued attributes. In short, firms exist not only to economize
on transaction costs, but also as a means for the exercise of entrepreneurial
judgment, and as a low-cost mechanism for entrepreneurs to experiment
with various combinations of heterogeneous capital goods. e boundary
changes discussed in chapter 3 can be understood as the result of processes
entrepreneur is not merely an idea man, but rather an owner, who exercises judgment
over the capital assets he owns and manages. is contrasts with Kirzner’s analytical device
of the “pure entrepreneur” who owns no capital. (I thank John Matthews for the reference
to Marchal.)
14 Ironically, the notion of capital as a homogeneous fund owes its popularity to Knight
(1936).

112
of entrepreneurial experimentation. And internal organization is a means
of delegating particular decision rights to subordinates who exercise derived
judgment (Foss, Foss, and Klein, 2007).
Witt (1998) offers another approach to combining an Austrian concept
of entrepreneurship with the theory of the firm. Entrepreneurs require
complementary factors of production, he argues, which are coordinated
within the firm. For the firm to be successful the entrepreneur must establish
a tacit, shared framework of goals—what Casson (2000) calls a
“mental model” of reality—which governs the relationships among members
of the entrepreneur’s team. As Langlois (1998) points out, it is often
easier (less costly) for individuals to commit to a specific individual—the
leader—rather than an abstract set of complex rules governing the firm’s
operations. e appropriate exercise of charismatic authority, then, facilitates
coordination within organizations (Witt, 2003). is approach
combines insights from economics, psychology, and sociology, and leans
heavily on Max Weber. Leaders coordinate through effective communication,
not only of explicit information, but also of mental models as
described above. e successful entrepreneur excels at communicating
such models. 15
Here, as in Coase (1937), the employment relationship is central to
the theory of the firm. e entrepreneur’s primary task is to coordinate
the human resources that make up the firm. e analysis in chapter 4, by
contrast, focuses on alienable assets, as in Knight (1921). It defines the firm
as the entrepreneur plus the alienable resources the entrepreneur owns and,
thus, controls. Each approach has strengths and weaknesses. e cognitive
approach explains the dynamics among team members, but not necessarily
their contractual relationships. Must charismatic leaders necessarily own
physical capital, or can they be employees or independent contractors?
Formulating a business plan, communicating a corporate culture, and the
like are clearly important dimensions of business leadership. But are they
attributes of the successful manager or the successful entrepreneur? Even
if top-level managerial skill were the same as entrepreneurship, it is unclear
why charismatic leadership should be regarded as more entrepreneurial
than other, comparatively mundane managerial tasks, such as structuring
15 Earl’s (2003) “connectionist approach” to entrepreneurship also focuses on coordination,
but here the emphasis is on coordination among market participants, not within
organizations. See also Koppl and Langlois (2001) and Langlois (2002).

113
incentives, limiting opportunism, administering rewards, and so on. On
the other hand, the judgment approach does not generalize easily from the
one-person firm to the multi-person firm.
Applications of Entrepreneurial Action
Shifting the focus of entrepreneurship research from opportunity identification
to entrepreneurial action suggests several new issues and directions
for entrepreneurship research.
Opportunities and Organizational Form
Distinguishing between opportunity discovery and entrepreneurial action
reminds us that the two do not always go hand in hand. Efforts to encourage
the former do not necessarily encourage the latter. Generally, efficiency
requires that entrepreneurs (and what Foss, Foss, and Klein, 2007 call
“proxy-entrepreneurs”) bear the full wealth effects of their actions. For this
reason, efforts to promote experimentation, creativity, etc., within the firm
can encourage moral hazard unless rewards and punishments are symmetric.
Outside the firm, strong intellectual property protection, incentives for
discovery (such as SBIR awards), and the like may encourage overspending
on discovery. e potential waste of resources on “patent races” is a wellknown
example (Barzel, 1968; Loury, 1979; Dasgupta and Stiglitz, 1980;
Judd, Schmedders, and Yeltekin, 2003).
By contrast, if the essence of entrepreneurship is the assembly of resources
under uncertainty, then the locus of entrepreneurship is not the
generation of creative ideas, but the funding of projects. Financiers—
venture capitalists, angel investors, banks, family members, even corporate
shareholders—are, in this sense, entrepreneurs. Resource owners possess
fundamental judgment rights that, by the nature of ownership, cannot be
delegated, no matter how many proximate decision rights are delegated
to subordinates (Foss, Foss, and Klein, 2007). In this perspective, even
corporate shareholders are treated not as passive suppliers of capital (as
they are treated both in neoclassical production theory and contemporary
entrepreneurship theory), but as critical decision-makers. 16
16 See the discussion in chapter 2 above on “firms as investments” and “financiers as
entrepreneurs.”

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Some applications, such as the staging of venture finance (Gompers,
1995), are obvious. Another application is the inherent uncertainty of
the gains from corporate takeovers. As discussed in chapter 2 above, the
“raider’s” return to a successful takeover is thus a form of pure entrepreneurial
profit. More generally, note that in this perspective, finance is
treated not as an input into the entrepreneurial process, but as the very
essence of that process. Entrepreneurship is, in other words, manifested in
investment. Of course, the terms “finance” and “investment” are used here
in a broad sense, referring to the provision not only of financial capital, but
also human capital, and tangible and intangible resources—anything that
can be considered an input or factor of production. Entrepreneurship is
conceived as the act of putting resources at risk, with profit as the reward for
anticipating future market conditions correctly, or at least more correctly
than other entrepreneurs.
Entrepreneurial Teams
Focusing on entrepreneurial action also responds to recent calls to link the
theory of entrepreneurship more closely to the theory of group behavior
(Stewart, 1989; Mosakowski, 1998; Cook and Plunkett, 2006). Some efforts
to develop a theory of team entrepreneurship focus on shared mental
models, team cognition, and other aspects of the process of identifying
opportunities. Penrose’s (1959) concept of the firm’s “subjective opportunity”
set is an obvious link to judgment-based theories of entrepreneurship
(Kor, et al., 2007). 17 Entrepreneurs can also form networks to share expectations
of the potential returns to projects (Greve and Salaff, 2003; Parker,
2008).
On the other hand, even if one views the perception of a (subjectively
identified) opportunity as an inherently individual act, entrepreneurial
action can be a team or group activity. Venture capital, later-stage private
equity, and bank loans are often syndicated. Publicly traded equity is
diffusely held. Professional services firms and closed-membership cooperatives
represent jointly owned pools of risk capital. Moreover, the firm’s
top management team—to whom key decision rights are delegated—can
17 Spender (2006, p. 2) argues that “Penrose’s model of managerial learning [is] an
accessible instance of the epistemological approach proposed by Austrian economists such
as Hayek, Kirzner, and Schumpeter.”

115
be regarded as a bundle of heterogeneous human resources, the interactions
among which are critical to the firm’s performance (Foss, et al., 2008).
is approach also suggests relationships between the theory of entrepreneurship
and the theory of collective action (Olson, 1965; Hansmann,
1996). Once an entrepreneurial opportunity has been perceived, the entrepreneur
may need to assemble a team of investors and/or a management
team, raising problems of internal governance. Shared objectives must be
formulated; different time horizons must be reconciled; free riding must be
mitigated; and so on. Cook and Plunkett (2006) and Chambers (2007)
discuss how these problems are addressed within closed-membership, or
new-generation cooperatives. Traditionally organized, open-membership
cooperatives suffer from what Cook (1995) calls vaguely defined property
rights. Because their equity shares are not alienable assets that trade in
secondary markets, traditional cooperatives suffer from a particular set of
free-rider, horizon, portfolio, control, and influence costs problems. 18
In response, a new type of cooperative began to emerge in the 1990s.
ese new-generation cooperatives required up-front equity investments
(in traditional cooperatives, equity is generated ex post, through retained
earnings), restricted patronage to member investors, and allowed for limited
transferability of investment and delivery rights. 19 One of the key
challenges in developing new-generation cooperatives is the establishment
of a founding investment team with shared objectives and constraints and
an effective governing board. According to project champions—those
entrepreneurs who formulated the original vision of the organization—the
biggest obstacle they faced was convincing other farmer investors, with
whom they had close social ties, to invest (Chambers, 2007). In other
words, the successful movement from opportunity identification to entrepreneurial
action depended critically on transaction cost and collective
action considerations, social capital, and reputation. Team entrepreneurship,
in the Knightian sense described above, is a subset of the general
theory of economic organization.
18 See Cook and Iliopoulos (2000) and Cook and Chaddad (2004) for details.
19 Cook, Burress, and Klein (2008) document the emergence of a cluster of newgeneration
cooperatives in the tiny community of Renville County, Minnesota.

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Summary and Conclusions
e arguments presented here suggest that the entrepreneurship literature
may have over-emphasized the origins and characteristics of entrepreneurial
opportunities. Instead, opportunities can be usefully treated as
a latent construct that is manifested in entrepreneurial action, namely the
exercise of judgment over the arrangement of heterogeneous capital assets.
e Austrian theory of capital, interpreted in the attributes framework
described above, provides a useful bridge between the Knightian theory of
entrepreneurship and the theory of economic organization. In short, this
chapter suggests a reorientation of the entrepreneurship literature toward
deeds, not words or dreams. In Rothbard’s (1985, p. 283) words: “Entrepreneurial
ideas without money are mere parlor games until the money
is obtained and committed to the projects.” Of course, the subjectivist
concept of resources is inextricably tied to beliefs—vision, imagination,
new mental models, if you like—but these beliefs are relevant only to the
extent that they are manifest in action.
One objection to this approach is to invoke recent literature in behavioral
economics and neuroeconomics. is literature takes preferences,
not choices, as its unit of analysis, seeking to understand the psychological
basis of preference, the consistency of preferences, and the like, rather than
taking preferences as an irreducible primary. Likewise, a theory of opportunity
identification could mimic the methods of behavioral economics
and neuroeconomics. is is, indeed, a potentially fruitful avenue for
entrepreneurship research. However, like behavioral economics, such an
approach has more in common with applied psychology than economics.
It may contribute to a general, interdisciplinary approach to entrepreneurship,
but is not an integral part of the economic theory of entrepreneurship
(see Gul and Pesendorfer, 2005, for a more general argument along these
lines).

CHAPTER 6
Risk, Uncertainty, and Economic Organization †
In a recent paper, “e Limits of Numerical Probability: Frank H. Knight
and Ludwig von Mises and the Frequency Interpretation,” Hans-Hermann
Hoppe (2007) explores Mises’s approach to probability and its implications
for economic forecasting. Hoppe argues that Mises, like Frank
Knight, subscribed to the “frequency interpretation” developed by Mises’s
brother, Richard von Mises (1939), along with others such as Ronald
Fisher, Jerzy Neyman, and Egon Pearson. At first, this might seem surprising,
as the frequency interpretation is usually contrasted with the
“subjectivist” approach to probability advanced by Finetti (1937) and,
among economists, usually associated with Keynes (1921). A thoroughgoing
commitment to methodological subjectivism is, of course, a hallmark
of the Austrian School. However, as Hoppe points out, Mises recognized
two distinct kinds of probability, one applying to natural phenomena and
another applying to human action. Just as Mises embraced “praxeology”
in economics while endorsing the experimental method in the natural
sciences, he thought a special kind of probability was relevant to economic
decision making, while accepting his brother’s frequency interpretation for
other kinds.
† Published originally in Jörg Guido Hülsmann and Stephan Kinsella, eds., Property,
Freedom, and Society: Essays in Honor of Hans-Hermann Hoppe (Auburn, Ala.: Ludwig von
Mises Institute, 2009), pp. 325–37.
117

118
is chapter extends the discussion by drawing out implications for
economic organization of Mises’s approach to probability, particularly regarding
the entrepreneur’s role in guiding the economic process by establishing
and dissolving firms, directing their operations, and organizing
them to create and capture value. After a brief review of Hoppe’s interpretation
of Knight and Mises, I summarize recent literature on the
Knight–Mises approach to entrepreneurship and the firm, closing with
some suggestions for future research.
Knight, Mises, and Mises on Probability
Most economists are familiar with Knight’s distinction between “risk” and
“uncertainty.” Risk refers to situations in which the outcome of an event
is unknown, but the decision maker knows the range of possible outcomes
and the probabilities of each, such that anyone with the same information
and beliefs would make the same prediction. Uncertainty, by contrast,
characterizes situations in which the range of possible outcomes, let alone
the relevant probabilities, is unknown. In this case the decision maker
cannot follow a formal decision rule but must rely on an intuitive understanding
of the situation—what Knight calls “judgment”—to anticipate
what may occur. Risk, in this sense, refers to “a quantity susceptible
of measurement,” and not a “true” uncertainty that cannot be quantified
(Knight, 1921, p. 26). e essential function of the entrepreneur,
in Knight’s system, is to exercise judgment, particularly in the context of
purchasing factors of production.
Mises, in similar fashion, distinguished between “class probability”
and “case probability.” e former describes situations in which an event
may be classified as a unique element of a homogeneous class, the properties
of which are known. No one can predict whether a particular house in
a particular neighborhood will burn down this year, but insurance companies
know how many similar houses in similar locations have burned in
the past, and from this the likelihood of a particular house burning within
a particular period can be estimated. Case probability applies to cases in
which each event is unique, such that no general class probabilities can
be defined. 1 Here Mises, as argued by Hoppe, builds on his brother’s
1 O’Driscoll and Rizzo (1985) adopt the terms “typical events” and “unique events” to
get at this distinction.

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defense of “frequentism,” the idea that the probability of a particular event
is the limit value of its relative frequency in a series of trials. In this
understanding, probabilities can be defined only in cases in which repeated
trials are feasible—i.e., in situations where each event can be meaningfully
compared to other events in the same class. Moreover, and for this reason,
probabilities can only be defined ex post, as learned through experience, and
cannot exist a priori. Hence, Mises defines case probability, or uncertainty,
as a case in which probabilities, in the frequentist sense, do not exist. 2
Hoppe (2007) summarizes Knight’s and Mises’s views and argues persuasively
that they are variants of Richard von Mises’s position. 3 Hoppe
also goes beyond Mises in explaining why human action, in Mises’s sense of
purposeful behavior, cannot be made part of a homogenous class. “Without
a specified collective and an (assumedly) full count of its individual
members and their various attributes no numerical probability statement
is possible (or is, if made, arbitrary)” (Hoppe, 2007, p. 10). Of course, as
Hoppe notes, we can define such classes in a technical sense—me writing
this chapter is an element of the class “economists writing book chapters”—but
defining the class is not sufficient for applying class probability
to an event. ere must also be randomness, or what Richard von Mises
(1939, p. 24) calls “complete lawlessness,” within the class. And yet, this
is not possible with human action:
It is in connection with this randomness requirement where Ludwig
von Mises (and presumably Knight) see insuperable difficulties
in applying probability theory to human actions. True, formallogically
for every single action a corresponding collective can be
defined. However, ontologically, human actions (whether of individuals
or groups) cannot be grouped in “true” collectives but must
be conceived as unique events. Why? As Ludwig von Mises would
presumably reply, the assumption that one knows nothing about
any particular event except its membership in a known class is false
2 Hence the use of the term “case probability” is misleading; what Mises really means
is “case non-probability,” or perhaps “case judgments without probabilities.” Confusingly,
Mises also argues elsewhere that “[o]nly preoccupation with the mathematical treatment
could result in the prejudice that probability always means frequency” (Mises, 1949,
p. 107). Van den Hauwe (2007) argues, in contrast to Hoppe, that Mises’s position is
in some ways closer to Keynes’s.
3 One might also include Shackle’s notion of “self-destructive, non-seriable” decisions.
See G.L.S. Schackle, Decision, Order, and Time in Human Affairs (Cambridge: Cambridge
University Press, 1961).

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in the case of human actions; or, as Richard von Mises would put
it, in the case of human actions we know a “selection rule” the
application of which leads to fundamental changes regarding the
relative frequency (likelihood) of the attribute in question (thus
ruling out the use of the probability calculus). (Hoppe, 2007,
p. 11)
Hoppe touches briefly upon, without treating in detail, the subjective
approach to probability, in which a priori probabilities are treated simply
as beliefs, rather than the outcome of some objective process of repeated
trial and observation. Hoppe quotes Richard von Mises’s (1939, p. 75)
remark that subjectivists such as Keynes fail to recognize “that if we know
nothing about a thing, we cannot say anything about its probability.” Adds
Mises (1939, p. 76): “e peculiar approach of the subjectivists lies in the
fact that they consider ‘I presume that these cases are equally probable,’ to
be equivalent to ‘ese cases are equally probable,’ since, for them, probability
is only a subjective notion.” Subjective probability has become central
in contemporary microeconomic theory, however, particularly with
the rise of Bayesian approaches to decision making. Agents acting under
conditions of uncertainty are assumed to have prior beliefs—correct or
incorrect—about the probabilities of various events. ese prior beliefs are
exogenous, they may be common to a group of agents or unique to a particular
agent, and they may or may not correspond to objective probabilities
(in the frequentist sense). e Bayesian approach focuses on the procedure
by which agents update these prior beliefs based on new information,
and this updating is assumed to take place according to a formal rule
(i.e., according to Bayes’s law). Hence, the ex post probability, in such
a problem, contains an “objective” element, even if it is a revision of a
purely subjective prior belief. 4
Langlois (1982) argues for a tight connection between subjectivism in
the Austrian sense of value theory and subjective probability theory, arguing
that probabilities should be interpreted as beliefs about information
structures, rather than objective events. “[I]t is not meaningful to talk
about ‘knowing’ a probability or a probability distribution. A probability
assessment reflects one’s state of information about an event; it is not some-
4 Bayesian updating can also be applied to objective prior probabilities, presumably to
give guidance to the decision maker in cases where repeated trials to determine the new ex
post probability are not possible. e “Monty Hall paradox” is a classic example.

121
thing ontologically separate whose value can be determined objectively”
(Langlois, 1982, p. 8).
What distinguishes case from class probability, according to Langlois,
is the character of the decision maker’s information about the event. Objective
probabilities (in the frequentist sense) are simply special cases of
subjective probabilities in which the decision maker structures the problem
in terms of classes of events. Entrepreneurship, in Langlois’s interpretation,
can be described as the act of formalizing the decision problem. To use
the language of decision theory, a non-entrepreneur (call him, following
Kirzner, 1973, a Robbinsian maximizer) is presented with a decision tree,
a set of outcomes, and the probabilities for each outcome, and simply uses
backwards induction to solve the problem. e entrepreneur, as it were, redraws
the tree, by noticing a possible option or outcome that other agents
failed to see. e key distinction, according to Langlois, is not whether
the decision tree is populated with objective or subjective probabilities,
but whether the tree itself is exogenous (Knightian risk) or endogenous
(Knightian uncertainty).
Hoppe follows Richard von Mises in rejecting the subjectivist position
(and obviously sees no contradiction between the frequentist approach to
probability and the subjective theory of value). It is not clear exactly what
is gained by redefining probabilities as “subjective with one information
set” or “subjective with another information set.” As discussed in the next
section, both Knight and Mises saw probability theory in economics as
playing a particular role, namely allowing the theorist to distinguish situations
in which prices are predictable, making profits and losses ephemeral,
and situations in which prices can only be anticipated, using some form of
judgment or Verstehen, by entrepreneurs. A subjectivist parameterization
of Verstehen may be possible, without being useful.
Uncertainty and the Entrepreneur
Neither Knight nor Mises focused primarily on individual decision making
per se, but on the role of decision making within the market system. “As
economists,” Hoppe (2007, p. 4) observes, Knight and Mises “come upon
the subject of probability indirectly, in conjunction with the question concerning
the source of entrepreneurial profits and losses.” 5 Indeed, while
5 See also Buchanan and Di Pierro (1980).

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Knight devotes a chapter of Risk, Uncertainty, and Profit to a detailed
discussion of knowledge, reasoning, and learning, his main purpose is not
to analyze the ontology of judgment, but to explain the practical workings
of the market. Specifically, his purpose in developing his account of probability
was to decompose business income into two constituent elements,
interest and profit. Interest is a reward for forgoing present consumption,
is determined by the relative time preferences of borrowers and lenders, and
would exist even in a world of certainty. Profit, by contrast, is a reward for
anticipating the uncertain future more accurately than others (e.g., purchasing
factors of production at market prices below the eventual selling
price of the product), and exists only in a world of “true” uncertainty. In
such a world, given that production takes time, entrepreneurs will earn
either profits or losses based on the differences between factor prices paid
and product prices received.
Ludwig von Mises, as discussed in chapter 5 above, gives uncertainty
a central role in his theory of profit and loss, and his account of the impossibility
of economic calculation under socialism. Because there are no
factor markets under socialism, there are no factor prices, and hence no
way for planners to choose efficiently among the virtually infinite range of
possibilities for combining heterogeneous resources to make a particular set
of consumer goods. Entrepreneurs under capitalism engage in this process
of “appraisement” every day, weighing possible combinations of factors
and trying to anticipate what consumers will buy and how much they’ll
pay once the final goods and services are ready. Profit and loss provides
essential feedback for entrepreneurs as they “test” their conjectures on the
market.
Why can’t a central planning board mimic the operations of entrepreneurs?
e key, for Mises, is that entrepreneurial appraisement is not a
mechanical process of computing expected values using known probabilities,
but a kind of Verstehen that cannot be formally modeled using decision
theory. e entrepreneur, Mises (1949, p. 582) writes, “is a speculator, a
man eager to utilize his opinion about the future structure of the market
for business operations promising profits.” e entrepreneur relies on
his “specific anticipative understanding of the conditions of the uncertain
future,” an understanding that “defies any rules and systematization.”
is concept of the entrepreneurial function is difficult to reconcile
with the optimization framework of neoclassical economics. In this frame-

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work, either decision making is “rational,” meaning that it can be represented
by formal decision rules, or it is purely random. T. W. Schultz
(1980, pp. 437–38) poses the problem this way:
[I]t is not sufficient to treat entrepreneurs solely as economic agents
who only collect windfalls and bear losses that are unanticipated. If
this is all they do, the much vaunted free enterprise system merely
distributes in some unspecified manner the windfalls and losses that
come as surprises. If entrepreneurship has some economic value it
must perform a useful function which is constrained by scarcity,
which implies that there is a supply and a demand for their services.
e key to understanding this passage is to recognize Schultz’s rejection,
following Friedman and Savage (1948), of Knightian uncertainty. If
all uncertainty can be parameterized in terms of (possibly subjective) probabilities,
then decision making in the absence of such probabilities must
be random. Any valuable kind of decision making must be modelable,
must have a marginal revenue product, and must be determined by supply
and demand. For Knight, however, decision making in the absence of a
formal decision rule or model (i.e., judgment) is not random, it is simply
not modelable. It does not have a supply curve, because it is a residual
or controlling factor that is inextricably linked with resource ownership.
As discussed above, it is a kind of understanding, or Verstehen, that defies
formal explanation but is rare and valuable. In short, without the concept
of Knightian uncertainty, Knight’s idea of entrepreneurial judgment makes
little sense.
Nor is judgment simply luck. 6 To be sure, one could imagine a model
in which entrepreneurs are systematically biased, as in Busenitz and Barney
(1997)—individuals become owner-entrepreneurs because they overestimate
their own ability to anticipate future prices—and the supply of
entrepreneurs is sufficiently large that at least a few guess correctly, and
earn profits. In such an economy there would be entrepreneurs, firms,
profits, and losses, and profit (under uncertainty) would be distinct from
interest. However, as Mises (1951) emphasizes, some individuals are more
adept than others, over time, at anticipating future market conditions,
and these individuals tend to acquire more resources while those whose
forecasting skills are poor tend to exit the market. Indeed, for Mises,
6 Demsetz (1983) compares Kirznerian alertness to luck.

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the entrepreneurial selection mechanism in which unsuccessful entrepreneurs—those
who systematically overbid for factors, relative to eventual
consumer demands—are eliminated from the market is the critical “market
process” of capitalism. 7
Conclusion
Uncertainty, in Knight’s and Ludwig von Mises’s sense, is thus fundamental
to understanding not only the profit-and-loss system, and the market’s
process of allocating productive resources to their highest-valued users,
but also the economic nature of the business firm itself. Unfortunately,
contemporary neoclassical economics tends to reject both the distinction
between case and class probability and the entrepreneur. If there is no
“true” uncertainty, then profits are the result of monopoly power or random
error. If any firm can do what any other firm does, if all firms are
always on their production possibility frontiers, and if firms always make
optimal choices of inputs, then there is little for the entrepreneur to do.
Fortunately, the modern entrepreneurship literature has begun to recognize
the need for a more sophisticated treatment of uncertainty (along
with other cognitive issues—see the discussion in Alvarez and Barney,
2007), and concepts of resource heterogeneity are common in the resourceand
knowledge-based views of the firm, transaction-cost economics, and
the real-options approach to the firm. Far from rehashing old controversies,
with the reexamination of Ludwig von Mises’s and Knight’s views on
uncertainty, Hoppe’s paper provides fresh insight into the entrepreneur,
the firm, and the market process.
7 See chapter 7 below.

CHAPTER 7
Price Theory and Austrian Economics †
e Austrian approach underlies all the chapters in this volume. Austrian
economics, I have argued, provides unique insight into the emergence,
boundaries, and internal organization of the firm. Likewise, firms operate
within a particular institutional context—they are the “islands of conscious
power in [the] ocean of unconscious cooperation like lumps of butter
coagulating in a pail of buttermilk” (D. H. Robertson, quoted in Coase
1937, p. 388). at “ocean of unconscious cooperation” is the market, and
Austrians have developed a unique understanding of the market economy
that sheds additional light into organizational and strategic issues.
Indeed, the Austrian school has experienced a remarkable renaissance
over the last five decades (Vaughn, 1994; Rothbard, 1995; Oakley, 1999;
Salerno, 1999b, 2002). Austrian economics flourished originally in Vienna
during the last three decades of the nineteenth century, and in Europe
and North America through the 1920s, and then entered a prolonged
eclipse in the 1930s and 1940s. Kept alive by important contributions
from Hayek (1948), Mises (1949), Lachmann (1956), Rothbard (1962),
Kirzner (1973), and others, the Austrian tradition emerged once more as
† Published as “e Mundane Economics of the Austrian School” in Quarterly Journal
of Austrian Economics 11, nos. 3–4 (2008): 165–87.
125

126
an organized movement in the 1970s, and remains today an important
alternative to the “mainstream” tradition of neoclassical economics.
But what exactly is the distinct contribution of the Austrian school?
How does it differ from other traditions, schools of thought, approaches,
or movements within economics and its sister disciplines? As a social
movement, the Austrian School possesses the formal markers usually taken
to demarcate a school of thought, such as its own institutions—specialized
journals, conferences, academic societies, and funding agencies—and the
patterns of self-citation emphasized by Crane (1972). Here, though, I am
concerned not with the sociology of the Austrian School, but with its core
theoretical doctrines, propositions, and modes of analysis, particularly as
they apply to everyday, pedestrian, ordinary economic problems. ese
are the basic problems of price theory, capital theory, monetary theory,
business-cycle theory, and the theory of interventionism, problems that
are central to any approach within economics.
Price theory—the theory of value, exchange, production, and market
intervention—was what Mises (1933, p. 214) had in mind when he made
the statement, often surprising to contemporary Austrians, that the Austrian,
Walrasian, and Jevonian versions of marginalism “differ only in their
mode of expressing the same fundamental idea and . . . are divided more
by their terminology and by peculiarities of presentation than by the substance
of their teachings.” ese are not the words of a young, enthusiastic
author yet to appreciate the important differences among rival schools of
thought; the essay was written in 1932, when Mises was a mature scholar.
Hayek, likewise, wrote in his 1968 entry for the International Encyclopedia
of the Social Sciences that his (fourth) generation of the Austrian School
can hardly any longer be seen as a separate school in the sense of
representing particular doctrines. A school has its greatest success
when it ceases as such to exist because its leading ideals have become
a part of the general dominant teaching. e Vienna school has to
a great extent come to enjoy such a success. Hayek (1968a, p. 52)
A few sentences later Hayek singles out “value and price theory” as the
key Austrian contribution to modern economics (recognizing, of course,
the influence of Marshall, and presumably Hicks, Allen, and Samuelson as
well).
ese statements hardly can mean that Mises and Hayek failed to recognize
the important distinctions among the three marginalist traditions,

127
given their substantial work on the methodology of the Austrian School
(Mises, 1933, 1962; Hayek, 1952a). Instead, they indicate that both Mises
and Hayek considered value and price theory to be central to the Austrian
tradition, an emphasis broadly shared among all theoretical economists.
Consider that Mises’s 1932 essay focuses on the differences between theoretical
economics and the historicism of the Younger German Historical
School. Indeed, Mises’s usual doctrinal targets were historicism, institutionalism,
and other forms of what he considered to be “anti-economics,”
not alternative versions of theoretical economics (let alone different strands
within the Austrian School). In the fight for theoretical economics, Mises
considered the Lausanne and British neoclassical tradition as allies. All
three marginalist traditions took value, price, exchange, and production
theory to be their central core. 1
Perhaps recognizing the close ties between Austrian value and price
theory and that of mainstream economics, recent commentators have
looked elsewhere for the distinguishing characteristics of the Austrian
School. D. Klein (2008, p. 361), for example, identifies the Hayekian
notion of “spontaneous order” as the main contribution of the Austrian
tradition, urging that the label “Austrian,” with its specific historical and
geographical connotations, be replaced by “spontaneous order economics”
or “Smith–Hayek economics.” Austrian economics, he argues, is part of a
broader tradition that includes key figures in the Scottish Enlightenment,
French classical liberals of the eighteenth and nineteenth century, and
twentieth-century thinkers such as Michael Polanyi. 2
1 Admittedly, Hayek’s 1968 assessment of the Austrian School’s influence is harder to
reconcile with his own insistence (Hayek, 1937, 1945, 1946) that neoclassical economists
had failed to appreciate the role of knowledge and expectations. Hayek remained ambivalent
on this point; in an unfinished draft for the New Palgrave Dictionary, written
around 1982 (and reprinted in Hayek, 1992, pp. 53–56), Hayek describes indifferencecurve
analysis as “the ultimate statement of more than half a century’s discussion in the
tradition of the Austrian School,” adding that “by the third quarter of the twentieth century
the Austrian School’s approach had become the leading form of microeconomic theory.”
But he goes on to identify the school’s “main achievement” as clarifying the differences
between “disciplines that deal with relatively simple phenomena, like mechanics, . .. and
the sciences of highly complex phenomena.”
2 Koppl urges Austrian economists to join what he calls the “heterodox mainstream,” a
body of literature embracing bounded rationality, rule following, institutions, cognition,
and evolution, or BRICE. Austrians have “an opportunity to contribute to the heterodox
mainstream of today and join, thereby, the emerging new orthodoxy of tomorrow” (Koppl,
2006, pp. 237–38).

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While I agree that the Austrian tradition is part of a larger, liberal
movement, I see Austrian economics as nonetheless a distinct kind of economic
analysis, and think that the essence of the Austrian approach is not
subjectivism, the market process (disequilibrium), or spontaneous order,
but what I call mundane economics—price theory, capital theory, monetary
theory, business-cycle theory, and the theory of interventionism. Call
this the “hard core” of Austrian economics. I maintain that this hard core
is (1) distinct, and not merely a verbal rendition of mid-twentieth-century
neoclassical economics; (2) the unique foundation for applied Austrian
analysis (political economy, social theory, business administration, and
the like); and (3) a living, evolving body of knowledge, rooted in classic
contributions of the past but not bound by them. 3
A different view is found in Vaughn’s (1994) influential book on the
modern Austrian movement. Vaughn’s characterization of the post-1974
“Austrian revival” has proved controversial (Gordon, 1995; Rothbard,
1995; Ekelund, 1997; ornton, 1999). Her interpretation of the first
three generations of the Austrian School, by contrast, has received relatively
little attention. Vaughn consistently characterizes the price theory
of Menger, Böhm-Bawerk, Mises, and Rothbard as backward-looking,
inconsistent, and often wrong. eir elaborations of mundane economics,
she says, are mainly verbal “neoclassical” economics, because they rely
heavily on equilibrium constructs; indeed, Menger’s price theory is that
of “half-formed neoclassical economist” (Vaughn, 1994, p. 19). Menger’s
distinctive Austrian contribution, Vaughn (1994, pp. 18–19) argues, is
“his many references to problems of knowledge and ignorance, his discussions
of the emergence and function of institutions, the importance
of articulating processes of adjustment, and his many references to the
progress of mankind.” ese issues, which attracted considerable attention
during the “Austrian revival” of the 1970s, are discussed in Menger’s 1883
book Untersuchungen über die Methode der Socialwissenschaften und der
politischen Oekonomie insbesondere [Investigations into the method of the
social sciences with special reference to economics]. ey are largely absent
from the Principles, however.
3 My focus here is economic theory, not methodology, so my point is different from
Rothbard’s (1995) argument that Misesian praxeology, not the alternative Popperian,
evolutionary epistemology of the later Hayek or the “radical subjectivism” of Lachmann,
is the proper starting point for Austrian economics.

129
Specifically, Vaughn maintains that there is a fundamental contradiction
in Menger and Mises’s understanding of markets because they simultaneously
employ equilibrium theorizing and talk about time, uncertainty,
“process,” and in Menger’s case, institutions. Mises’s Human Action, for
example, combined “some fundamental Mengerian insights with the apparatus
of neoclassical price theory to the detriment of both” (Vaughn,
1994, p. 70).
is chapter argues against this characterization of Menger, Mises,
and their contemporaries. As explained below, Austrian economists from
Menger to Rothbard were fully aware of time, uncertainty, knowledge,
expectations, institutions, and market processes. Indeed, their understanding
of these issues was sophisticated. ey employed equilibrium theorizing,
but in a precise and deliberate manner. ey understood clearly
the distinction between their own understandings of mundane economics
and that of their Walrasian and Jevonian colleagues. ey devoted their
energies to developing and communicating the principles of mundane economics,
not because they failed to grasp the importance of knowledge,
process, and coordination, but because they regarded these latter issues as
subordinate to the main task of economic science, namely the construction
of a more satisfactory theory of value, production, exchange, price, money,
capital, and intervention.
My contention is that mundane Austrian economics not only provides
a solid foundation for addressing conventional economic questions
about markets and industries, regulation, comparative economic systems,
macroeconomic fluctuations, trade, and growth, but also helps place organizational
and managerial issues in sharper relief. A mistaken focus on
subjectivism, spontaneous order, radical uncertainty, and the like as the
essence of the Austrian contribution has led management scholars to overlook
the importance of the Austrian theories of price formation, capital,
money, and economic fluctuations, theories that have important implications
for firms and entrepreneurs.
Central Themes of Austrian Economics Before 1974
Before 1974, the bulk of Austrian economics dealt with mundane economic
subjects. Menger’s Principles (1871), for example, deals entirely
with value, price, and exchange (plus a short section on money). Menger

130
intended the Principles as an introduction to a longer, more comprehensive
work. e planned sequel was never written, but from Menger’s notes,
Hayek (1934, p. 69) tells us, “we know that the second part was to treat
‘interest, wages, rent, income, credit, and paper money,’ a third ‘applied’
part the theory of production and commerce, while a fourth part was to
discuss criticism of the present economic system and proposals for economic
reform.” e three volumes of Böhm-Bawerk’s great treatise, Capital
and Interest (1884–1912), deal primarily with capital and interest theory
but also include the famous sections (in volume II, Positive eory of Capital)
on value and price, introducing the “marginal-pairs” approach to price
formation. Wieser’s Social Economics (1914) ranges more widely, as did
Wieser throughout his career, but still focuses primarily on fundamental
questions of value, exchange, production, factor pricing, and international
trade. e Anglo-American economists influenced by the Austrians—Phillip
Wicksteed, Frank Fetter, Henry Davenport, and J. B. Clark,
for example—also viewed the core of Austrian economics as its theory of
value and exchange, not knowledge, expectations, and disequilibrium. 4
Possibly the most striking example of an Austrian commitment to
mundane economics is Rothbard’s Man, Economy, and State (1962). Of
the 12 chapters in the original edition, all but two focus on the details of
value, price, exchange, capital, money, competition, and the like. (Chapter
1 deals with methodological and ontological issues, chapter 12 with
the theory of government intervention.) Production theory alone gets five
chapters. Even if Power and Market is included, the book contains little
about subjective expectations, learning, equilibration, emergent orders,
and the like. Perhaps for this reason, Vaughn (1994, p. 96) states that
4 Interestingly, the third- and fourth-generation Austrians were thoroughly steeped not
only in the writings of their Viennese predecessors, but also those of the Anglo-American
Mengerian price theorists. Hayek (1963a, p. 32) notes that “in the early post-war period
the work of the American theorists John Bates Clark, omas Nixon Carver, Irving Fisher,
Frank Fetter, and Herbert Joseph Davenport was more familiar to us in Vienna than that of
any other foreign economists except perhaps the Swedes.” Hayek quotes a letter from Clark
to Robert Zuckerkandl in which Clark praises Zuckerkandl’s eory of Price (1899), saying
“[n]othing gives me greater pleasure than to render full honor to the eminent thinkers,
mainly Austrians, who were earlier in this field than myself, and who have carried their
analysis to greater lengths” (Hayek, 1939a, p. 39) Hayek adds that “at least some of the
members of the second or third generation of the Austrian School owed nearly as much to
the teaching of J. B. Clark as to their immediate teachers.” Salerno (2006) discusses Clark’s
influence on Mises.

131
Rothbard’s treatise “must have seemed to a typical reader to be more or
less familiar economics presented almost exclusively in words with a few
controversial definitions, and some strange discontinuous graphs.”
Man, Economy, and State was of course intended as a more elementary
and systematic presentation of the contents of Mises’s Human Action
(1949), which covers a broader range of philosophical, historical, and sociological
subjects (Stromberg, 2004). Human Action begins, for example,
with a lengthy methodological and ontological sections and chapters on
“Time” and “Uncertainty.” Still, the bulk of the book—the 16 chapters
comprising Parts 3, 4, and 5—deal with the core economic subjects of
value, price, and exchange. e same is true, at least partly, of another important
postwar contribution to Austrian economics, Lachmann’s Capital
and Its Structure (1956). Lachmann’s book includes lengthy and insightful
discussions of expectations (chapter 2) and “process analysis” (chapter
3), defined as “a causal-genetic method of studying economic change,
tracing the effects of decisions made independently of each other by a
number of individuals through time, and showing how the incompatibility
of these decisions after a time necessitates their revision” (Lachmann,
1956, p. 39). 5 What Lachmann has in mind here is the continual readjustment
of the economy’s capital structure—he calls it “reshuffling” and
“regrouping”—as firms experiment with various combinations of capital
goods. Clearly, however, Lachmann has a specific purpose in mind,
namely explaining the implications of capital heterogeneity for the theory
of production, economic growth, and the business cycle. e book is not
focused primarily on meta-theoretic concerns, but on the economic theory
of capital itself.
e main exception to this pattern is Hayek, whose influential essays
on knowledge (Hayek, 1937, 1945) and competition (Hayek, 1948) appeared
in the middle of the century. 6 Of course, Hayek’s reputation at this
time was based on his technical contributions to monetary and businesscycle
theory (see the essays collected in Hayek, 2008), and Hayek’s main
interests, from his first writings in the late 1920s until his move to Chicago
5 Lachmann cites Hicks (1939), Lindahl (1939), and Lundberg (1937) as the main
exponents of process analysis, though these theorists are not usually included in the
contemporary “market process” tradition.
6 Morgenstern (1935) also deals with expectations and their role in the formation of
economic equilibria.

132
in 1950, remained economic theory, conventionally defined. 7 More generally,
while many members and fellow travelers of the Austrian School
wrote on broad social themes, all regarded technical economics as the heart
of the Mengerian project.
By contrast, O’Driscoll and Rizzo’s Economics of Time and Ignorance
(1985) contains only a few references to Menger and none to Böhm-
Bawerk (outside Roger Garrison’s chapter on capital). After an introduction
it contains chapters on “Static versus Dynamic Subjectivism,”
“Knowledge and Decisions,” “e Dynamic Conception of Time,” and
“Uncertainty in Equilibrium.” An application section follows, which features
chapters on “Competition and Discovery,” “e Political Economy
of Competition and Monopoly,” and chapters on capital and money. At
least half of the book, then, deals with ontological or meta-theoretic issues
while the core principles of valuation, price formation, and production
theory occupy relatively little space. Or consider the edited volume e
Market Process: Essays in Contemporary Austrian Economics (Boettke and
Prychitko, 1994). Of the book’s five main parts, only one, “Money and
Banking,” deals primarily with a conventional economic subject; a section
on “Cost and Choice” includes a chapter on utility theory, but even this
chapter is primarily ontological, while the remaining sections focus on
meta-theoretic issues (with an applied section on political economy).
One might infer that these works take the basic body of causal-realist
price theory as given, as so well established that further elaboration is
unnecessary, thus preferring to concentrate on advanced applications,
methodological foundations, critiques, and so on. However, as attested by
the statements from Vaughn (1994) quoted above, Austrians after 1974 by
7 By the 1950s, Hayek tells us,
I had . . . become somewhat stale as an economist and felt much out of
sympathy with the direction in which economics was developing. ough
I had still regarded the work I had done during the 1940s on scientific
method, the history of ideas, and political theory as temporary excursions
into another field, I found it difficult to return to systematic teaching of
economic theory and felt it rather as a release that I was not forced to do
so by my teaching duties. (1994, p. 126)
roughout his career at the London School of Economics from 1932 to 1949, Hayek’s
main teaching obligation had been the required graduate course in economic theory. Of
course, he did produce his first important work in classical liberal political economy, e
Road to Serfdom, in 1944.

133
no means accepted the core principles of Austrian price theory as correct,
or even as a distinct approach at all, as opposed to a verbal rendition of
Walrasian and Marshallian economics. Instead, Austrians after 1974 have
tended to regard issues like knowledge, uncertainty, and process as the
distinct contribution of the Austrian School.
As noted above, for Vaughn (1994) the most “Austrian” of the classic
Austrian texts is Menger’s 1883 collection of methodological essays.
ese essays attempted to defend Menger’s theoretical approach against the
methods of the (Younger) German Historical School provoking the fierce
reaction by Gustav Schmoller and his followers that became a full-blown
Methodenstreit. Here Menger presents his theory of “organic” institutions,
what Hayek (1973–79, p. 43) termed “spontaneous order.” 8 How is it
possible, Menger (1883, p. 146) asks, “that institutions which serve the
common welfare and are extremely significant for its development come
into being without a common will directed toward establishing them?”
Menger’s (1892) essay on money provides a detailed example of this process,
in which a commonly accepted medium of exchange emerges as a byproduct
of individual traders’ decisions to adopt particular commodities as
money. A monetary standard, in this sense, is the “result of human action
but not the result of human design” (Hayek, 1948, p. 7). 9 Do these ideas
relate to the price theory outlined in Menger’s Principles, from which they
are largely absent?
First, note that the passage dealing with spontaneous order occupies
just two short chapters (30 pages in the 1981 English edition) in a 16-
chapter (237-page) book. ese chapters are undeniably profound and
have exerted an important influence on later Austrians’ understanding of
social phenomena (White, 1981). However, the bulk of the text deals with
Menger’s defense of economics as a “theoretical science,” with “exact laws,”
rather than a historical science dealing with historically contingent, “national
economies.” Second, Menger’s examples of organic phenomena are
not limited to language, religion, law, competition, and money. Indeed,
Menger introduces the concept of emergent social processes with a more
mundane example: prices.
8 See Klein (1997) and Klein and Orsborn (2009) on the differences between Menger’s
account of institutions and Hayek’s understanding of spontaneous order. Klein (1997)
argues that Menger’s notion of coordination is closer to Schelling’s (1978) than Hayek’s.
9 See also Klein and Selgin (2000).

134
[We] could point to a long series of phenomena of this kind. We
intend, however, to set forth the above idea by an example that is
so striking that it excludes any doubt of the meaning of what we
plan to present here. We mean the example of the social prices
[i.e., market prices] of goods. As is well known, there are in individual
cases completely or at least in part the result of positive social
factors, e.g., prices under the sway of tax and wage laws, etc. But
as a rule these are formed and changed free of any state influence
directed toward regulating them, free of any social agreement, as
unintended results of social movement. e same thing holds true
of interest on capital, ground rents, speculative profit, etc. (Menger,
1883, p. 146)
In other words, Menger’s concept of spontaneous order is simply the process
by which voluntary interaction establishes social regularities such as
prices, wages, interest rates, and rents. Not only is the market system itself
a product of spontaneous order, in this sense, but so are individual market
prices.
Menger’s presentation here challenges the usual distinction (Davis
and North, 1971) between the institutional environment (or “rules of the
game”) and the institutional arrangements (the “play of the game”) that
emerge in that environment. e new institutional economics (Klein,
2000; Williamson, 2000) typically treats the former—the legal system,
language, norms and customs—as the results of human action but not
human design, while the latter—firms, contracts, the terms of specific
transactions—are seen as the product of deliberate design by particular
agents. Menger treats both kinds of institutions as “spontaneous,”
meaning (generally) undirected by state planners. In other words, for
Menger, price theory is not a technical discipline independent of research
on spontaneous orders; price theory is spontaneous-order research. Again,
in Menger’s (1883, pp. 158–59) words:
[M]arket prices, wages, interest rates, etc., have come into existence
in exactly the same way as those social institutions which we mentioned
in the previous section. For they, too, as a rule are not the
result of socially teleological causes, but the unintended result of
innumerable efforts of economic subjects pursuing individual interests....
e methods for the exact understanding of the origin of
the “organically” created social structures and those for the solution
of the main problems of exact economics are by nature identical.

135
Equilibrium in Austrian Price Theory
Menger’s economics, as has been documented elsewhere (Caldwell, 1990;
Salerno, 1999a; Klein, 2006), is causal-realist, marginalist, and subjectivist.
Despite frequent assertions that Austrian economics is defined as
“market process economics” or “disequilibrium economics,” the concept of
equilibrium features prominently in causal-realist economics (Hülsmann,
2000; MacKenzie, 2008) At least four distinct equilibrium constructs appear
in Austrian analysis. Following Mises’s terminology, as amended by
Salerno (1994a), we can call them the plain state of rest (PSR), the fully
arbitraged state of rest or Wicksteedian state of rest (WSR), the final state
of rest (FSR), and the evenly rotating economy (ERE). Two of these, the
PSR and WSR, describe real-world outcomes, while the FSR and ERE are
what Mises called “imaginary constructions,” hypothetical scenarios that
do not obtain in reality, but are useful in economic reasoning, allowing the
theorist to isolate the effects of particular actions or circumstances, holding
all else constant.
e PSR obtains every day in the real world, each time a buyer and
seller agree on a price and make an exchange, momentarily exhausting the
gains from trade. (Menger called these “points of rest”; Böhm-Bawerk,
“momentary equilibria.”) A set of potential buyers and sellers interacting
in a defined market space can also be described as being in a PSR once the
trading period is completed. “When the stock market closes, the brokers
have carried out all orders which could be executed at the market price.
Only those potential sellers and buyers who consider the market prices
too low or too high respectively have not sold or bought” (Mises, 1949,
p. 245). At this point “[a] state of rest emerges.” e PSR persists as long
as market participants’ relative valuations of the goods and services being
exchanged (including speculative demands) remain constant.
PSR prices are not necessarily those that would emerge in the “final
state of rest” (FSR), a hypothetical situation, never actually achieved, following
a sequence of events in which the basic data of the market are frozen
but market participants continue to trade, revising their beliefs about other
participants’ reservation prices and obtaining better information about
technological possibilities and consumer demands, until all feasible gains
from trade are exhausted. After analyzing the PSR, “[w]e go a step further.
We pay attention to factors which are bound to bring about a tendency

136
toward price changes. We try to find out to what goal this tendency must
lead before all its driving force is exhausted and a new state of rest emerges”
Mises (1949, p. 246). In the real economy, of course, these underlying
factors are constantly changing, and hence the FSR is never achieved. 10
e FSR is used to trace the effects of changes in tastes, technology,
expectations, resource availability, and other exogenous variables on patterns
of resource allocation by focusing on a sequence of PSR equilibria in
which market participants adjust their behavior until all gains from trade
have been exhausted. As Salerno (2006) explains,
FSR analysis also begins from a fully adjusted economy in which
profits are currently zero. However in this construction the past
and future are relevant to economic planning. Alterations in the
economic data are permitted to occur but only one at a time and
with a lapse of time between changes sufficiently long to permit a
complete adjustment of prices and production in the economy to
each change, thus resulting in the emergence of a new zero-profit
FSR before another change in the economic data can occur. During
the transition to the new FSR, profits and losses appear across the
economy spurring entrepreneurs to shuffle and reshuffle resources
and capital combinations to take advantage of profit opportunities
and avoid losses.
Salerno (2006) notes that Mises modeled his construct after Clark’s notion
of “dynamic” equilibrium, similar to what is called “comparative statics”
in contemporary neoclassical economics. Mises “used Clark’s construct
in formulating a ‘step-by step’ or ‘process’ analysis logically demonstrating
the sequence of changes which occur throughout the entire interdependent
system of markets in the transition to the new FSR”—for example, in
10 Machlup (1958, p. 57) seems to have the FSR in mind when he writes:
To characterize a concrete situation “observed” in reality as one of “equilibrium”
is to commit the fallacy of misplaced concreteness. At best, the
observer may mean to assert that in his opinion the observed and duly
identified situation corresponds to a model in his mind in which a set of
selected variables determine a certain outcome, and that he finds no inherent
cause of change—that is, that he believes only an outside disturbance,
not in evidence at the moment, could produce a change in these variables.
is, of course, is a personal judgment, meaningful only if the variables are
fully enumerated and the assumptions about their interrelations are clearly
stated.

137
tracing the effects of an increase in the money supply on prices and resource
allocation. (Modern comparative statics, however, as formalized by Hicks,
1939, and Samuelson, 1947, abstracts from the element of time.)
It is important to emphasize that the movement from PSR to FSR takes
place in analytical time, not calendar time; FSR analysis is a logical exercise,
not meant to explain the sequence of events taking place in real markets,
for the underlying “data” are in constant flux. is point is not well
understood, even among Austrians. For example, Boettke and Prychitko
(1994) caution against overreliance on equilibrium theorizing in Austrian
economics, even characterizing some of the classic contributions to Austrian
economics as “neoclassical Austrianism.” 11 “When Austrians refer to
proximity to an end state in their treatment of entrepreneurship they may
be relying too much on the equilibrium construct” (Boettke and Prychitko,
1994, p. 65). However, the causal-realistic price theory of Menger and
his followers does not make any assumptions about the “proximity” of
PSR or WSR prices to their FSR values in calendar time. Instead, the
theorist uses the imaginary construction of the FSR to explain what pattern
of activities and ownership would obtain following an exogenous change
in preferences, resource availability, or technological knowledge, holding
all else constant. e causal-realist theorist does not assume that such
adjustments take place in calendar time; indeed, this imaginary process
would be impossible in a world in which preferences, stocks, technology,
and the like are constantly changing.
Lying between the PSR and the FSR is the WSR, a realistic concept
in which trading takes place while preferences remain constant, with market
participants revising their beliefs about other participants’ reservation
prices until all feasible gains from trade are exhausted. Wicksteed’s (1910,
pp. 219–28) fruit market provides the canonical example. 12 By the end of
each market day, a specified period in which preferences, stocks of goods,
and the set of traders remains fixed, what Wicksteed calls “the equilibrating
price” has been achieved. In this situation, “the marginal position of the
commodity in question is identical upon the relative scales of all who have
11 ough specific Austrian writings are not identified, a footnote refers to “relevant
sections” of Mises (1949), Rothbard (1962), Kirzner (1973, 1979, 1985b) and High
(1980, 1982, 1986) as “neoclassical Austrianism.”
12 See also Marget (1938–42, vol. 2), Kirzner (1963, pp. 105–35) and Salerno (1994a,
pp. 97–106).

138
secured a supply, and higher on them all than it is on the scales of any of
those who have secured no supply” (Wicksteed, 1910, p. 216). e market
day is a hypothetical construct, in that it holds only as long as preferences,
technical knowledge, stocks of goods available for exchange, and so on are
held constant. And yet, the WSR is not a purely imaginary construction,
as this process of equilibration takes place in real markets, at least over
short periods of calendar time.
Assuming the underlying data are unchanged, [this] approach
yields a coherent explanation of how, as information becomes
more complete and speculation more accurate, PSRs succeed one
another until the intermediate equilibrium situation represented
by a fully-arbitraged state of rest (or WSR) is brought into being.
(Salerno, 1994a, p. 102)
e ERE, used by Mises (1949, pp. 247–51) and Rothbard (1962,
pp. 320–28), serves a more limited function. e ERE is an imaginary
construction in which preferences, technology, and resource availability
are held constant and agents are assumed to repeat the same set of actions
each market day. Economic activity takes place—there is production,
consumption, saving, and investment—but entrepreneurs can predict the
future with certainty. e main function of the ERE is to show that in
the absence of uncertainty, factor prices would be bid up to their full
discounted marginal revenue products, eliminating entrepreneurial profit
and loss. Business owners would still earn interest income if they advance
wages to workers and other factor owners before production is completed
and sales receipts are realized, and they can earn implicit wages on the
labor they supply to the firm, but there can be no profits and losses. Only
by using such a construction, Mises argued, can the theorist decompose
real-world business income into interest, the owner’s implicit wage, and
entrepreneurial profit. 13
As noted above, the PSR and WSR are intended as realistic phenomena,
not hypothetical constructs (like the FSR and ERE). Marshall’s
“market-day equilibrium” is also intended to explain real-world pricing in
markets, something like Wicksteed’s WSR, but includes arbitrary assump-
13 For additional discussion see Cowen and Fink (1985), Gunning (1989), and MacKenzie
(2008).

139
tions about the marginal utility of money (Walker, 1969). 14 Likewise,
Hicks’s “temporary equilibrium”—a form of Walrasian general equilibrium
that incorporates agents’ expectations of prices that will obtain in
future trading periods—shares elements of the Austrian WSR. However,
it is, like Walrasian equilibrium, a deliberately artificial construct, not
meant to explain actual market prices but as a modeling step in explaining
a concept of intertemporal equilibrium (De Vroey, 2002).
Before 1974, then, Austrian economists used the realistic equilibrium
constructs of the PSR and WSR, and the imaginary constructions of the
FSR and ERE, to explain the basic phenomena of value, production, exchange,
and price. eir work was built on Menger’s value theory and
its underlying concepts of purpose, subjectivism, and uncertainty, and the
extensions of the Mengerian approach to deal with price formation under
direct exchange (Böhm-Bawerk’s horse market, Wicksteed’s fruit market),
monetary calculation and indirect exchange, capital theory (the time structure
of production and the heterogeneity of capital goods), FSR analysis,
the effects of government intervention (business-cycle theory, regulation),
and other mundane aspects of commercial life.
Knowledge, Expectations, and the Convergence to Equilibrium
Since the “Austrian revival” of the 1970s the mundane economic subjects
described above have commanded relatively little attention. e most popular
issues and topics among modern Austrians have included fractionalreserve
“free banking,” political economy, and the methodological foundations
of the Austrian School. During the 1980s, a lengthy debate took
place over the existence of “equilibrating tendencies” in the market economy,
with Kirzner and Lachmann representing opposite positions (Selgin,
1988). Kirzner argued that the existence of profit opportunities under disequilibrium,
and that the tendency of alert entrepreneurs to discover and
exploit these opportunities, was sufficient to establish a general, systematic
tendency toward equilibrium. Lachmann, in contrast, maintained that in
the face of “radical” uncertainty, including subjective expectations, equilibrating
tendencies could not be assumed, absent some explanation for
14 Just as Mises’s (hypothetical) FSR results from a sequence of PSRs, Marshall’s “normal
equilibrium” is brought about by a series of market-day equilibria (De Vroey, 2002).

140
learning. Knowledge, expectations, and the convergence to equilibrium
came to occupy center stage in the Austrian research program.
My purpose in this section is not to analyze this debate, but to ask
why the problem of convergence to equilibrium received so little attention
in early Austrian writings. Neither Menger, Böhm-Bawerk, Wieser, the
Anglo-American Austrians, nor Mises devoted much effort to this issue. If
the presence or absence of equilibrating tendencies in the entrepreneurial
market process is the central problem of price theory, why did the early
Austrians fail to recognize it?
First, the modern Austrian literature uses the term equilibrium quite
broadly and often inconsistently. O’Driscoll and Rizzo (1985, p. 39),
for example, refer to “correct” and “incorrect” prices, identifying the
latter with “non-equilibrium” prices, although the equilibrium construct
is not defined or discussed in detail until much later in the discussion.
Vaughn (1994) refers to “equilibrium models” (p. 2), “equilibrium states”
(p. 3), “equilibrium theorizing” (p. 8), “equilibrium constructs” (p. 11),
and more—all within the first dozen pages!—but does not provide a formal
definition of any equilibrium concept until the discussion of Mises in her
fourth chapter (pp. 81–82). ere she characterizes Mises’s distinction
among three equilibrium constructs (PSR, FSR, and ERE) as “surprisingly
unsatisfying” (p. 81), seemingly treating the PSR and FSR as equivalent to
Marshallian short-run and long-run partial equilibrium, respectively, and
the ERE as Mises’s own idiosyncratic, and unhelpful, construction. 15
More generally, the modern Austrian literature on “disequilibrium” is
not always careful to define the concept of equilibrium, and virtually never
discusses distinctions among the PSR, WSR, FSR, or ERE. O’Driscoll and
Rizzo (1985, pp. 80–85) argue that modern Austrians typically have some
notion of “plan coordination” in mind. Indeed, all four equilibrium constructs
described above involve a form of plan coordination, in the sense
that individuals engaged in exchange hold shared beliefs about what is to be
exchanged, what price will be paid, and so on. However, as O’Driscoll and
Rizzo (1985, p. 80) observe, plan coordination—they call it “Hayekian
equilibrium”—is a very general concept; it “can be partial or general, and
15 Inexplicably, she accuses Rothbard (1962) of confusing the FSR and ERE, though
without providing any specific page reference (Vaughn, 1994, p. 82, n 35). She also says
Mises “seemed to confuse his two [sic] distinct notions of equilibrium.”

141
can prevail over the various ‘runs’ of Marshallian time.” 16 Plans can be
said to be “coordinated” in the PSR, in the limited sense of coordination
just mentioned, without being “coordinated” in any broader sense, as in
a longer period of time, a larger set of potential traders or bundles of
goods. As O’Driscoll and Rizzo (1985, pp. 80–81) put it: “Hayekian
equilibrium therefore must entail homogenous expectations with respect
to the time period within which equilibrium prevails. Outside of that
period, however, expectations can, and sometimes must, be divergent.”
ey go on to conclude that Hayekian equilibrium, in any form, cannot be
obtained in real exchange. “Hayek and the other Austrians did not realize
that equilibrium is not a directly operational construct and that the real
world was never in equilibrium” (p. 81). is is clearly false, however, with
respect to the PSR (and, to a weaker extent, the WSR), when expressed in
“plan coordination” terms.
Rothbard (1962) is somewhat imprecise in distinguishing among equilibrium
constructs. His discussion of price determination (pp. 79–186,
and passim) focuses mainly on PSR prices, though he occasionally refers to
prices that “tend toward” their (WSR) equilibrium values. As described
above, every price paid in an actual transaction is a PSR price, so the
concept of a market price tending toward its PSR value makes little sense.
PSR prices can, of course, be what the Walrasian literature calls “false
prices,” meaning that they differ from their WSR or FSR values.
In his treatment of expectations Rothbard (1962, pp. 130–37) notes
that the formation of PSR prices does not assume perfect knowledge. Indeed,
the supply and demand curves underlying PSR analysis incorporate
market participants’ expectations of future price changes, expectations that
may or may not be consistent with those of other market participants. If
expectations are incorrect, then shortages and surpluses emerge as market
participants trade at PSR prices—Rothbard (1962, p. 134) calls them
“provisional resting point[s]”—that differ from their values once these
price differences have been arbitraged away (a state of affairs presumably
like the WSR, though Rothbard is not explicit on this point). As these
shortages and surpluses are revealed, market participants will adjust their
16 Kirzner (2000) argues for a more nuanced appreciation of Hayek’s commitment to
“plan coordination,” arguing (against O’Driscoll, 1977) that Hayek was ambivalent on the
proper notion of coordination in economics. For more on concepts of coordination see
Klein (1997) and Klein and Orsborn (2009).

142
expectations until the fully arbitraged price, what Rothbard here calls the
“genuine equilibrium price,” emerges. Rothbard does, then, assume a
simple learning process, though he does not spell out the details of this
process. However, his assumptions about knowledge and the ability of
market participants to learn from their mistakes (“speculative errors”) are
minimal. Market participants are assumed to adjust their expectations
about the PSR prices that emerge moment-to-moment, in the markets
in which these traders are active. In other words, these are very short-run
expectations, not long-run expectations (in the Marshallian sense of the
long run).
Likewise, the Austrian price theory of Böhm-Bawerk, Wicksteed, Fetter,
Mises, and Rothbard treats the movement of prices from PSR to WSR
values as a straightforward process. It does not require “perfect knowledge,”
only that agents are aware of surpluses and shortages (from trading
at false prices) and that they adjust their bids accordingly. As noted above,
agents’ expectations about other agents’ preferences are already incorporated
into the reservation bids and asks. While these writers were not as
explicit about their assumptions concerning knowledge and expectations
as Mayer (1932), Hayek (1937, 1945) and the later Austrians, they were
hardly unaware of processes underlying market clearing. Wicksteed, for
example, is explicit that forecast errors explain the deviation of PSR prices
(the “actual price”) from their WSR equivalents (the “ideal price”):
A market is the machinery by which those on whose scales of preference
any commodity is relatively high are brought into communication
with those on whose scales it is relatively low, in order that
exchanges may take place to mutual satisfaction until equilibrium
is established. But this process will always and necessarily occupy
time. e persons potentially constituting the market will not all
be present at the same time, and therefore the composition of the
collective scale (on which, together with the total amount of the
commodity in existence, the ideal point of equilibrium depends)
must be a matter of estimate and conjecture. e transactions actually
conducted at any moment will be determined in relation to the
anticipated possibilities of transactions at other moments. Speculation
as to these fixture possibilities will be more or less elaborate
and conscious according to the nature of the market and the length
of time over which the adjustment will be likely to extend. But
speculation is always present when any possessor of the commodity
refuses to sell at the moment at a price which he knows he will be

143
prepared to accept ultimately (whether an hour or eleven months
hence), if satisfied that he can do no better; or if any purchaser
refuses at the moment to give a price to which he knows he will
ultimately be willing to rise should the alternative be to go without
the commodity; or if any one buys at a price below which he
would ultimately sell sooner than keep the stock for his own use.
(Wicksteed, 1910, p. 236)
ese forecast errors are revealed, Wicksteed (1910, p. 236) continues, as
traders exchange at non-WSR prices in real time:
If no one at first has a correct conception of the facts, a series of
tentative estimates, and the observation of the transactions that
take place under their influence, may gradually reveal them; and if
we could eliminate all error from speculative estimates and could
reduce derivative preferences to exact correspondence with the
primary preferences which they represent, and on which they are
based, the actual price would always correspond with the ideal
price.
Salerno (1994a, p. 105) notes that Mises, in e eory of Money and
Credit, invokes arbitrage in his account of purchasing power parity (Mises,
1912, pp. 195–203). “e money price of any commodity in any place,
under the assumption of completely unrestricted exchange and disregarding
the differences arising from the time taken in transit, must be the same
as the price at any other place, augmented or diminished by the money
cost of transport” (Mises, 1912, pp. 196–97). Hence, Mises argues,
the purchasing power of money shows a tendency to come to the
same level throughout the world, and that the alleged differences
in it are almost entirely explicable by differences in the quality of the
commodities offered and demanded, so that there is only a small and
almost negligible remainder left over, that is due to differences in
the quality of the offered and demanded money.
e existence of the tendency itself is hardly questioned.
(p. 198; emphasis in original)
Mises continues:
Nobody would wish to dispute the fact that costs of production
differ greatly from one another in different localities. But it must be
denied that this exercises an influence on the price of commodities
and on the purchasing power of money. e contrary follows too

144
clearly from the principles of the theory of prices, and is too clearly
demonstrated day by day in the market, to need any special proof
in addition. e consumer who seeks the cheapest supply and the
producer who seeks the most paying sale concur in the endeavor
to liberate prices from the limitations of the local market. (Mises,
1912, pp. 199–200)
Note that Mises treats the “tendency” of the purchasing power of money
to equalize across and within markets, less transportation costs, as “clearly
demonstrated day by day in the market,” i.e., as an empirical fact not
requiring special explanation.
Here it is worth emphasizing a methodological point. For modern,
neoclassical economists, the instrumentalist approach (Friedman,
1953) renders moot many such questions about the mechanics underlying
market-clearing processes. e goal of economic theory, in this approach,
is not to explain actual prices, but to explain hypothetical prices (for example,
full-information prices, Nash equilibrium prices, perfectly competitive
prices, and the like). It is unlikely that Menger and his followers, steeped
in the causal-realist tradition, would simply assume that “equilibrium”
obtains—after all, they were seeking to explain real prices, not hypothetical
ones. ey saw the processes of buyers and sellers making bids and asks,
of revising their offers in light of new information, and so on as real-world
phenomena, not instrumental constructs like the Walrasian tâtonnement. 17
Lachmann (1977, p. 189), while expressing reservations about the log-
17 De Vroey (2002, pp. 406–07) argues that Marshall, too, regarded his market-day
equilibrium construct as both realistic and practical, i.e., not requiring an underlying
adjustment process:
Two adjustment processes are present in Marshall: the adjustment toward
market-day equilibrium and the adjustment toward normal equilibrium.
In my view . .. the former should be interpreted as proceeding instantaneously,
whereas the latter (to be called intertemporal adjustment) arises
across several trading rounds....
e stationary equilibrium concept of equilibrium is in accord with
the common-sense understanding of equilibrium—i.e., it is a point of
rest. It is implied that this point does not need to be effectively reached;
it suffices that reacting forces are triggered whenever it is not reached.
Equilibrium is thus viewed as an attractor.... Note also that in this line of
thought, assessing the existence of equilibrium or disequilibrium amounts
to making a statement about reality.

145
ical consistency of market-level equilibrium constructs such as the WSR,
nonetheless recognized that Menger’s points of rest, Böhm-Bawerk’s momentary
equilibrium, and Mises’s plain state of rest represent real phenomena:
e Austrians were concerned, in the first place, with the individual
in household and business. ere is no doubt that here equilibrium
has a clear meaning and real significance. Men really aim at
bringing their various actions into consistency. Here a tendency
towards equilibrium is not only a necessary concept of praxeology,
but also a fact of experience. It is part of the logic inherent in human
action. Interindividual equilibrium, such as that on a simple
market, like Böhm-Bawerk’s horse market, already raises problems
but still makes sense. “Equilibrium of an industry” à la Marshall is
already more precarious. “Equilibrium of the economic system as
a whole,” as Walras and Pareto conceived of it, is certainly open to
Mises’s [anti-equilibrium] strictures.
In other words, the deliberately unrealistic character of the equilibrium
constructs that dominate neoclassical economics—and, by implication,
Austrian concepts like the FSR and ERE—does not render the equilibrium
concept itself unrealistic.
Clearly, the Mengerian price theorists did not assume that real prices
were FSR or ERE prices. ey allowed for subjective, heterogeneous beliefs
about changes in demand, resource availability, and knowledge. And Mises
(1949, p. 247) is clear that the movement from the PSR to the FSR takes
place in analytical time, not calendar time. “Between the appearance of a
new datum and the perfect adjustment of the market to it some time must
pass. (And, of course, while this period of time elapses, other new data
appear.)” In other words, the real economy does not converge on a FSR
because as the market is adjusting to one change in the data, another takes
place, the combined effects of which cannot be known ex ante. Hence the
accuracy of real-world expectations is not central to this approach. ese
theorists make no assumptions about the tendency or PSR and WSR prices
to converge toward some “final” values.
What about “radical uncertainty”? One can perhaps imagine a market
in which PSR prices do not “converge” toward WSR prices because of
endogenous, subjective expectations. However, as discussed above, it is
not clear that such a case has much practical significance, because the

146
movement from the PSR to the WSR requires only modest assumptions
about knowledge (namely, the ability of market participants to learn from
their mistakes). Even in the simplest, pure-exchange economy, Mengerian
price theory allows traders to have subjective expectations relevant to that
particular market (i.e., beliefs about other traders’ preferences), expectations
that are incorporated into the PSR supply and demand curves.
Vaughn (1994, p. 91) argues that much stronger assumptions about
knowledge and expectations are necessary for economic analysis, even (presumably)
for Mengerian price theory:
If all action is speculation, if people are constantly reevaluating
their preferences, if entrepreneurs make losses as well as profits, can
we be so certain that markets are fundamentally orderly? Perhaps
our world is one in which individual rationality leads to overall
waste and error.... Even more to the point, in a world of constant
change, how can people’s plans come to be realized? Why are
speculators likely to be more right about entrepreneurial prospects
than the entrepreneurs themselves? And how is successful rational
action distinguishable from pure luck? What are the regularities
in economic life that can be counted on to lend stability and predictability
to an otherwise bewildering world?
Most likely Menger, Böhm-Bawerk, Wieser, Mises, and their Viennese
contemporaries would have been baffled by the last statement in the
quotation above. e science of economics, in Menger’s formulation, is
about the explanation of regularities—the “exact laws” of reality described
in the Investigations. As Menger wrote to Walras in 1884:
It is rather necessary that we go back to the most simple elements
of the mostly very complex phenomena that are here in question—that
we thus determine in an analytical manner the ultimate
factors that constitute the phenomena, the prices, and that we
then accord to these elements the importance that corresponds to
their nature, and that, in keeping with this importance, we try to
establish the laws according to which the complex phenomena of
human interaction result from simple phenomena. (Quoted in
Hülsmann, 2007, p. 106)
As Bastiat (1850) observed, Paris gets fed. e task of economics is to
explain why.

147
e early Austrians’ emphasis on order helps us understand Mises’s
and Hayek’s statements, quoted at the beginning of the chapter, about the
close relationship between Austrian and neoclassical economics. Menger,
Walras, and Jevons all sought to explain the regularities of economic life.
e historicists, by contrast, saw the economy as a chaotic flood that defied
rational explanation. Indeed, some contemporary interpretations of Austrian
economics seem to place it closer to the German Historical School
than the Austrian School. Vaughn (1994, p. 90) for example, writes of
Mises:
[W]hat about sources of discoordination and disorder in [free, unhampered]
markets? Mises really had very little to say about such
problems, and in fact one concludes that he thought disorder was
a relatively minor problem.... [T]he only obvious sources of instability
or disorder in his system were the consequences of bad
banking institutions and destabilizing intervention on the part of
government. Trade cycles were brought about by misguided credit
policies. Unemployment was a consequence of minimum wage
rates. Inflation was an increase in the quantity of money brought
about by government policy. Externalities were the consequence of
imperfectly specified property rights. He never considered possible
sources of disorder internal to the market; disorder was an exogenous
phenomenon brought about by government regulation. . . .
In this attitude ... Mises is really not very different from many
neoclassical economic theorists (although perhaps more consistent
and more outspoken than others who shared his basic evaluation
of the market).
I think Vaughn is correct that Mises thought “disorder,” in the sense
she describes above, was a “relatively minor problem.” For Mises, economic
theory is the analysis of coordination—not the idea of “plan coordination”
often associated with Hayek, or what O’Driscoll and Rizzo (1985) call
“pattern coordination,” but what Mises, following W. H. Hutt, described
as “price coordination” (Salerno, 1991). is coordination, as noted below
does not require any assumptions about the tendency of PSR or WSR
prices to converge to FSR values. Full coordination of plans occurs only
in the ERE, a hypothetical state of affairs that does not (indeed, could
not) occur in the real economy. For Mises, following Clark (1899), the
FSR is an analytical device used to isolate the effects of specific changes in
preferences, beliefs, resource availability, productive technology, and the

148
like on the allocation of resources. 18
What does Mises mean by coordination, outside an imaginary world
of perfect knowledge, consistent expectations, “rational” behavior, and the
other assumptions of the First and Second Welfare eorems of neoclassical
economics? How, in other words, can Mises justify the efficiency of
resource allocation under capitalism without making strong assumptions
about the closeness of real-world prices to some idealized, or “correct,”
prices?
Central to the neoclassical notion of efficiency is the idea that only FSR
prices count for assessing the welfare properties of the market. 19 A primary
objective of Kirzner’s account of the entrepreneurial market process is to
show that the movement from PSR prices to their Marshallian/Walrasian
FSR equivalents is not automatic and instantaneous, but the result of entrepreneurial
behavior. In Kirzner’s framework, the market does possess equilibrating
tendencies, but these tendencies are not exogenous, but result
from the actions of entrepreneurs alert to the profit opportunities created
by temporary trading at false, i.e., non-FSR, prices. For Kirzner, PSR
prices themselves are not particularly important; what matters is whether
they tend to converge toward their FSR values. Kirzner’s concept of alertness
can thus be seen as an addendum to the neoclassical understanding of
market equilibrium. Kirzner’s approach, as Boettke and Prychitko (1994,
p. 3) describe it, “provided the disequilibrium foundations of equilibrium
economics that were required to complete the neoclassical project of explicating
the operating principles of the price system.” Kirzner’s objective,
in this sense, is to justify the use of FSR, or near-FSR, prices in welfare
analysis. If the market possesses equilibrating tendencies, then the welfare
theorems of neoclassical economics are reasonable criteria for assessing
market performance, and the main talk of welfare economics should be
the analysis of these tendencies and of market interventions that inhibit
the process of equilibration (Kirzner, 1988b). 20
18 Note that Clark (1907, p. 96) describes simple FSR analysis or comparative statics—e.g.,
if the supply increases, the price will fall, ceteris paribus—as obvious, as what
he calls a “commercial fact.”
19 And these FSR prices are only “efficient” in perfectly competitive markets; any degree
of asymmetric information renders economic outcomes inefficient (Grossman, 1980).
20 Adds Boettke (2005):
Why is all this important? Well as Franklin Fischer pointed out in his very

149
Salerno (1991, 1999b) offers a different interpretation of Mises, arguing
that Mengerian price theory is primarily a theory of PSR prices, not
FSR prices. In this view, the existence or nonexistence of equilibrating
tendencies in the unhampered market—the issue that divided “Kirznerians”
and “Lachmannians,” and dominated much of the Austrian discussion
in the 1980s—is relatively unimportant. For Mises, the critical “market
process” is not the convergence to equilibrium, but the selection mechanism
in which unsuccessful entrepreneurs—those who systematically overbid
for factors, relative to eventual consumer demands—are eliminated
from the market (Mises, 1951). In this context, the recent debate over
“de-homogenizing” Mises and Hayek (Rothbard, 1991; Salerno, 1993,
1994b, 1996b; Yeager, 1994, 1995, 1997; Herbener, 1996; Hoppe, 1996;
Stalebrink, 2004) deals not simply with the socialist calculation debate
or second-order distinctions between “calculation” and “knowledge,” but
with a fundamentally new interpretation of Austrian price theory, a causalrealist
approach to the market that differs in important ways from the Marshallian/Walrasian
analysis that fills the contemporary textbooks. Austrian
economics, in this view, is not simply neoclassical microeconomics—what
Caldwell (2004, pp. 328–88) calls “basic economic reasoning”—plus the
Mises–Hayek theory of the business cycle plus knowledge, process, plan
coordination, and spontaneous order, but a fundamentally different kind
of microeconomics. 21
important book e Disequilibrium Foundations of Equilibrium Economics
(1983) that unless we have good reasons to believe in the systemic tendency
toward equilibrium we have no justification at all in upholding the welfare
properties of equilibrium economics. In other words, without the sort
of explanation that Kirzner provides the entire enterprise of neoclassical
equilibrium is little more than a leap of faith.
If one rejects the neoclassical equilibrium concept as a welfare benchmark,
though, this justification is unnecessary.
21 Caldwell (2004, p. 333) argues that Austrians accept “the simple (although unrealistic)
models used for basic economic reasoning,” such as supply-and-demand analysis, at least
for market-level predictions. But Menger’s analysis, while “abstract,” is not “unrealistic”
in the sense of Walras’s or Marshall’s models of market exchange. In Long’s (2006) terminology,
Austrians reject “precisive abstraction,” in which false assumptions are deliberately
included to simplify the analysis, while embracing “non-precisive abstraction,” in which
certain characteristics of the situation are simply not specified. In other words, the “basic
economic reasoning” of the Austrians is different from the basic economic reasoning of
neoclassical economics.

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In a recent response to Salerno, Kirzner (1999) takes a characteristically
subtle position on the relationship between PSR and FSR prices. He argues
the PSR is an “equilibrium” only in a trivial sense and that PSR prices are
not meaningful for assessing the welfare properties of markets. He also
recognizes that PSR analysis was important to Mises. To solve this seeming
contradiction, he says that Mises used the PSR only to defend the concept
of consumer sovereignty, not for analysis of the market process. However,
if PSR prices are sufficient to assure that production is satisfying consumer
wants, it is unclear why FSR prices are important, and why one would care
about the alleged tendency of PSR prices to reach them.
A New Way Forward for Austrian Economics: Developing Austrian
Price Theory
e main argument of this chapter is that Austrian economics is primarily
mundane economics—the theory and applications of value, production,
exchange, price, capital, money, the firm, regulation, comparative institutions,
and other “mainstream” topics. What makes Austrian economics
unique is its causal-realist approach to these issues, not its attention to adjustment
processes, the formation of knowledge and expectations, spontaneous
order, plan or pattern coordination, radical subjectivism, and other
manifestations of “disequilibrium” economics. Such issues are interesting
and potentially important, but are ultimately subordinate to the main task
of economic analysis, the development, extension, application, and refinement
of the mundane Austrian tradition established by Menger. Naturally,
this means that students of Austrian economics must invest significant time
in mastering the existing literature before engaging in their own creative
restatement and revision.
As noted in chapters 4 and 5, Austrian economics is attracting increasing
attention among applied researchers in strategic management, organizational
economics, and the theory of the firm. Often the value-added of
Austrian economics in these fields is seen as its emphasis on disequilibrium,
which seems to fit the profit-seeking approach of strategic management
better than do neoclassical partial- and general-equilibrium models. Here
a more sophisticated and nuanced understanding of equilibrium would be
helpful, however. Organizational structures that are implemented, contracts
that are signed and executed, and other business arrangements that

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take place in real markets are equilibrium phenomena, in the PSR sense of
equilibrium. ey should be explainable using the same causal-realistic
mechanism used by the Austrians to explain real prices and quantities.
FSR analysis, as practiced by Mises, should also apply here: how, for instance,
does the profit-and-loss mechanism provide incentives for agents to
restructure PSR arrangements so that they move toward their FSR equivalents?
How do changes in regulation or other aspects of public policy,
or exogenous changes in the competitive or technological environments,
replace one PSR with another?
Unfortunately, despite the pleas of modern Austrians for more analysis
of “process,” very little progress has been made in this area within
the Austrian literature. Indeed, the bulk of the work during the last few
decades in evolutionary economics, dynamic programming, evolutionary
game theory, Bayesian learning models, agent-based simulations, complexity
theory, and so on, is fundamentally acausal and nonrealistic, an
extension of the mathematical economics of the late nineteenth and early
twentieth centuries. O’Driscoll and Rizzo (1985, pp. 65–66) cite some
examples of these literatures, implying that they are “Hayekian” in spirit;
however, despite sharing certain keywords with Austrian economics, it is
unclear that these research programs have been influenced in any way by
the core contributions or approach of the Austrian School.
Of course, the argument here is not that knowledge, expectations, and
process are unimportant, or that they should be ignored by Austrians (or
by any social scientists), but that they are secondary, and valuable only
to the extent they help construct a more satisfactory theory of markets
and prices. Austrian economics emerged as a causal, realistic alternative
to the historicism of its day, and remains today an alternative both to
mechanistic neoclassical economics and to the non-economics of old-style
institutionalism. Without a commitment to preserving and extending the
hard core of Austrian price theory, the distinct place of the Austrian School
will be lost.

CHAPTER 8
Commentary
A
Government Did Invent the Internet, But the Market Made
it Glorious †
Libertarians often cite the Internet as a case in point that liberty is the
mother of innovation. Opponents quickly counter that the Internet was a
government program, proving once again that markets must be guided by
the steady hand of the state. In one sense, the critics are correct, though
not in ways they understand.
e Internet indeed began as a typical government program, the
ARPANET, designed to share mainframe computing power and to establish
a secure military communications network. Of course, the designers
could not have foreseen what the (commercial) Internet has become. Still,
this reality has important implications for how the Internet works—and
explains why there are so many roadblocks in the continued development
of online technologies. It is only thanks to market participants that the
Internet became something other than a typical government program,
characterized by inefficiency, overcapitalization, and irrelevance.
In fact, the role of the government in the creation of the Internet is
† Published originally on Mises.org, June 12, 2006.
153

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often understated. e Internet owes its very existence to the state and to
state funding. e story begins with ARPA, created in 1957 in response
to the Soviets’ launch of Sputnik, and established to research the efficient
use of computers for civilian and military applications.
During the 1960s, the RAND Corporation had begun to think about
how to design a military communications network that would be invulnerable
to a nuclear attack. Paul Baran, a RAND researcher whose work was
financed by the Air Force, produced a classified report in 1964 proposing
a radical solution to this communication problem. Baran envisioned a
decentralized network of different types of “host” computers, without any
central switchboard, designed to operate even if parts of it were destroyed.
e network would consist of several “nodes,” each equal in authority, each
capable of sending and receiving pieces of data.
Each data fragment could thus travel one of several routes to its destination,
such that no one part of the network would be completely dependent
on the existence of another part. An experimental network of
this type, funded by ARPA and thus known as ARPANET, was established
at four universities in 1969. Researchers at any one of the four
nodes could share information, and could operate any one of the other
machines remotely, over the new network. (Actually, former ARPA head
Charles Herzfeld says that distributing computing power over a network,
rather than creating a secure military command-and-control system, was
the ARPANET’s original goal, though this is a minority view.)
By 1972, the number of host computers connected to the ARPANET
had increased to 37. Because it was so easy to send and retrieve data, within
a few years the ARPANET became less a network for shared computing
than what has been called “a high-speed, federally subsidized, electronic
post office.” e main traffic on the ARPANET did not consist of longdistance
computing, but news and personal messages.
As parts of the ARPANET were declassified, commercial networks
began to be connected to it. Any type of computer using a particular
communications standard, or “protocol,” was capable of sending and receiving
information across the network. e design of these protocols was
contracted out to private universities such as Stanford and the University of
London, and was financed by a variety of federal agencies. e major thoroughfares
or “trunk lines” continued to be financed by the Department of
Defense. By the early 1980s, private use of the ARPA communications

155
protocol—what is now called “TCP/IP”—far exceeded military use. In
1984 the National Science Foundation assumed the responsibility of building
and maintaining the trunk lines or “backbones.” (ARPANET formally
expired in 1989; by that time hardly anybody noticed). e NSF’s Office
of Advanced Computing financed the Internet’s infrastructure from 1984
until 1994, when the backbones were privatized.
In short, both the design and implementation of the Internet have
relied almost exclusively on government dollars. e fact that its designers
envisioned a packet-switching network has serious implications for how
the Internet actually works. For example, packet switching is a great technology
for file transfers, email, and web browsing but not necessarily the
best for real-time applications like video and audio feeds, and, to a lesser
extent, server-based applications.
Furthermore, without any mechanism for pricing individual packets,
the network is overused, like any public good. Every packet is assigned an
equal priority. A packet containing a surgeon’s diagnosis of an emergency
medical procedure has exactly the same chance of getting through as a
packet containing part of a pop star’s latest single or an online gamer’s
instruction to smite his foe. Because the sender’s marginal cost of each
transmission is effectively zero, the network is overused, and often congested.
Like any essentially unowned resource, an open-ended packetswitching
network suffers from what Garrett Hardin famously called the
“Tragedy of the Commons.”
In no sense can we say that packet-switching is the “right” technology.
One of my favorite quotes on this subject comes from Michael Hauben
and Ronda Hauben’s Netizens: On the History and Impact of Usenet and the
Internet (1995):
e current global computer network has been developed by scientists
and researchers and users who were free of market forces.
Because of the government oversight and subsidy of network development,
these network pioneers were not under the time pressures
or bottom-line restraints that dominate commercial ventures.
erefore, they could contribute the time and labor needed to make
sure the problems were solved. And most were doing so to contribute
to the networking community.
In other words, the designers of the Internet were “free” from the constraint
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We must be very careful not to describe the Internet as a “private”
technology, a spontaneous order, or a shining example of capitalistic ingenuity.
It is none of these. Of course, almost all of the Internet’s current
applications—unforeseen by its original designers—have been developed
in the private sector. (Unfortunately, the original web and the web browser
are not among them, having been designed by the state-funded European
Laboratory for Particle Physics (CERN) and the University of Illinois’s
NCSA.) And today’s Internet would be impossible without the heroic efforts
at Xerox PARC and Apple to develop a useable graphical user interface
(GUI), a lightweight and durable mouse, and the Ethernet protocol. Still,
none of these would have been viable without the huge investment of
public dollars that brought the network into existence in the first place.
Now, it is easy to admire the technology of the Internet. I marvel at
it every day. But technological value is not the same as economic value.
at can only be determined by the free choice of consumers to buy or
not to buy. e ARPANET may well have been technologically superior
to any commercial networks that existed at the time, just as Betamax may
have been technologically superior to VHS, the MacOS to MS-DOS, and
Dvorak to QWERTY. (Actually Dvorak wasn’t.) But the products and
features valued by engineers are not always the same as those valued by
consumers. Markets select for economic superiority, not technological
superiority (even in the presence of nefarious “network effects,” as shown
convincingly by Liebowitz and Margolis, 1990, 1995, 1999).
Libertarian Internet enthusiasts tend to forget the fallacy of the broken
window. We see the Internet. We see its uses. We see the benefits it brings.
We surf the web and check our email and download our music. But we will
never see the technologies that weren’t developed because the resources that
would have been used to develop them were confiscated by the Defense
Department and given to Stanford engineers. Likewise, I may admire the
majesty and grandeur of an Egyptian pyramid, a TVA dam, or a Saturn V
rocket, but it doesn’t follow that I think they should have been created, let
alone at taxpayer expense.
What kind of global computer network would the market have selected?
We can only guess. Maybe it would be more like the commercial
online networks such as Comcast or MSN, or the private bulletin boards
of the 1980s. Most likely, it would use some kind of pricing schedule,
where different charges would be assessed for different types of transmis-

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sions. Unfortunately, the whole idea of pricing the Internet as a scarce
resource—though we usually don’t notice this, bandwidth is scarce given
current technology—is ignored in most proposals to legislate network neutrality,
a form of “network socialism” that can only stymie the Internet’s
continued growth and development. e net neutrality debate takes place
in the shadow of government intervention. So too the debate over the
division of the spectrum for wireless transmission. Any resource the government
controls will be allocated based on political priorities.
Let us conclude: yes, the government was the founder of the Internet.
As a result, we are left with a panoply of lingering inefficiencies, misallocations,
abuses, and political favoritism. In other words, government
involvement accounts for the Internet’s continuing problems, while the
market should get the credit for its glories.
B Networks, Social Production, and Private Property †
Yochai Benkler’s e Wealth of Networks is a comprehensive, informative,
and challenging meditation on the rise of the “networked information
economy” and its implications for society, politics, and culture. Benkler
is a leading authority on the law, economics, and politics of networks,
innovation, intellectual property, and the Internet, and he puts his wide
knowledge and deep understanding to good use. He argues that the digital
revolution is more revolutionary than has been recognized, even by its
most passionate defenders. e new information and communications
technologies do not simply make the old ways of doing things more efficient,
but also support fundamentally new ways of doing things. In
particular, the past few years have seen the rise of social production, a
radically decentralized, distributed mode of interaction that Benkler calls
“commons-based peer production.”
Peer production involves the creation and dissemination of “user-generated
content,” including Wikipedia and open-source software, such as
† Published originally as a review of Yochai Benkler, e Wealth of Networks: How Social
Production Transforms Markets and Freedom, reviewed in e Independent Review 13, no. 3
(Winter 2009).

158
Linux, that allow users to generate their own entries and modify those created
by others. Commons-based peer production is characterized by weak
property rights, an emphasis on intrinsic rather than extrinsic (monetary)
rewards, and the exploitation of dispersed, tacit knowledge. (Some readers
will immediately think of Hayek’s concept of the market as generator and
transmitter of knowledge, though Hayek does not figure prominently in
the book.)
e Wealth of Networks is divided into three main parts. e first deals
with the economics of the networked information economy. is is welltrod
ground, having been explored in detail in Shapiro and Varian (1998),
Liebowitz and Margolis (1999), and other works, but Benkler’s treatment
is nevertheless insightful, intelligent, and engaging. e characteristics
of information as an economic good—high fixed costs and low marginal
costs; the ability to be consumed without exhaustion; the difficulty of
excluding “free-riders”—support the widespread use of commons-based
peer production.
Benkler proposes social production as an alternative to the traditional
organizational modes of market and hierarchy, in Oliver Williamson’s terminology.
Indeed, open-source production differs in important ways from
spot-market interaction and production within the private firm. But here,
as elsewhere, Benkler tends to overstate the novelty of social production.
Firms, for example, have long employed internal markets; delegated decision
rights throughout the organization; formed themselves into networks,
clusters, and alliances; and otherwise taken advantage of openness and
collaboration. Many different organizational forms proliferate within the
matrix of private-property rights. Peer production is not new; rather, the
relevant question concerns the magnitude of the changes.
Here, the book suffers from a problem common to others in this genre.
Benkler provides a wealth of anecdotes to illustrate the new economy’s
revolutionary nature, but little information on magnitudes. How new?
How large? How much? Cooperative, social production itself is hardly
novel, as any reader of “I, Pencil” (Read, 1958) can attest. Before the web
page, there was the pamphlet; before the Internet, the telegraph; before
the Yahoo directory, the phone book; before the personal computer, electric
service, the refrigerator, the washing machine, the telephone, and the
VCR. In short, such breathlessly touted phenomena as network effects, the
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assets are not novel. (Tom Standage’s [1998] history of the telegraph and
its revolutionary impact, e Victorian Internet, is well worth reading in
this regard.)
Part two, “e Political Economy of Property and Commons,” is the
book’s most original, provocative, and—for me—frustrating section. Benkler
sees social production as a powerful force for individual liberty. People
used to be passive recipients of news, information, norms, and culture; now
they are active creators. Each participant in an open-source project, each
creator of user-generated content on Wikipedia or YouTube, “has decided
to take advantage of some combination of technical, organizational, and
social conditions within which we have come to live, and to become an
active creator in his or her world, rather than merely to accept what was
already there. e belief that it is possible to make something valuable
happen in the world, and the practice of actually acting on that belief, represent
a qualitative improvement in the condition of individual freedom”
(Benkler, 2006, p. 137).
What Benkler means by “freedom” and “liberty,” however, is not the
classical liberal notion of the absence of state coercion, but the modern
liberal view of “autonomy,” individuals’ ability to achieve their goals
without restraints, voluntary or otherwise. is understanding of liberty,
which originates with Kant and Rousseau, is central to Benkler’s political
economy. Autonomy means that “individuals are less susceptible to manipulation
by a legally defined class of others—the owners of communications
infrastructure and media” (Benkler, 2006, p. 9)—hence Benkler’s sympathy
for the commons, an institutional framework in which property rights
are held not by individuals, but by a collective. It does not matter for Benkler
whether the collective is a private club, such as the participants of an
open-source project or the subscribers to a particular information service or
the state. What matters is how the commons facilitates “freedom of action”
in comparison to how a system of private-property rights affords freedom.
Benkler strongly opposes privatizing the information commons by allowing
owners to exercise property rights. He chides Cisco Systems, for
example, for designing and deploying “smart routers” that allow broadband
service providers to control the flows of packets through their systems
(for example, giving priority to some forms of content over others).
is action is akin to erecting toll gates on the Information Superhighway.
To ensure open access to the networked economy, Benkler (2006,

160
p. 21) favors a public ownership network infrastructure, loose enforcement
of intellectual property rights, subsidized R&D, and “strategic regulatory
interventions to negate monopoly control over essential resources in the
digital environment.”
is approach has some problems. First, although information itself
cannot be “owned,” the tangible media in which information is embedded
and transmitted are scarce economic goods. Information may yearn to be
“free,” but cables, switches, routers, disk drives, microprocessors, and the
like yearn to be owned. Such innovations do not spring from nowhere;
they are the creations of profit-seeking entrepreneurs that consumers or
other entrepreneurs purchase to use as they see fit. Of course, private
property can be nationalized. Federal, state, and local governments can
own broadband lines as they own streets and highways, or they can treat
network infrastructure as a regulated public utility. If these resources are
to be treated as public goods, then what about computers, iPods, and cell
phones? Are these gateways to the Information Superhighway also part of
the digital commons? If individuals can own cell phones, can they sign
contracts with service providers to deliver whatever content is mutually
agreed upon? Content providers and consumers are free to terminate their
agreements if they are unhappy. In this sense, a private property regime
allows as much “autonomy,” in the libertarian sense, as a commons-based
system. Moreover, if one takes into account the problems of collective
ownership, about which Benkler is largely silent, the case for the commons
becomes even more problematic.
Second, Benkler appears to adopt the Frankfurt school view of consumers
as passive recipients of culture, easily manipulated by powerful
corporate interests. “From the perspective of liberal political theory, the
kind of open-participatory, transparent folk culture that is emerging in the
networked environment is normatively more attractive than was the industrial
cultural production system typified by Hollywood and the recording
industry” (Benkler, 2006, p. 277). However, as Cowen (1998), Cantor
(2001), and others have argued convincingly, commercial culture—which
properly includes Elizabethan theater, classical music, and the Victorian
novel, as well as television, movies, and popular music—has always been
participatory in the broad sense Benkler describes. Far from being passive
consumers of culture, individuals have played an active role in shaping the
plays, books, songs, and shows made available to them simply by deciding

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to buy or not to buy, to patronize or not to patronize, to support or reject
particular producers and particular products. e main difference today is
that technological change—the advent of digital technology, cheap infrastructure,
and the like—has lowered the costs of entry (production costs,
distribution costs, and so forth), giving consumers additional options besides
voice and exit. Is this difference one of degree or kind?
Moreover, in any model of social and cultural production, opinion
makers play an important role. Even today, on political blogs and other
forms of user-generated content, the range of acceptable opinion among
the dominant sites, the ones at the left-hand side of Anderson’s (2006)
“long tail,” is hardly broader than what one finds in the New York Times or
the Wall Street Journal. Yes, a great deal of user-generated content exists,
but most of it is ignored and is unlikely to have any lasting influence.
An elite group of gatekeepers, Hayek’s “second-hand dealers in ideas,”
continues to exercise an important influence on social, political, and cultural
trends. In this sense, Benkler seems influenced, ironically, by the
perfectly competitive general equilibrium model of neoclassical economics,
with its assumption that all agents possess complete, perfect information.
He worries: private ownership of digital resources “gives some people the
power to control the options perceived by, or the preferences of, others,
[which] is ... a law that harms autonomy” (Benkler, 2006, p. 149). In a
world of subjective knowledge and beliefs and of dispersed, tacit knowledge,
how can everyone have the same perceived options? Elsewhere he
dismisses the effectiveness of competition as a means of enabling “autonomy”
under private ownership because of transaction costs. In other
words, competition must be “perfect” to be effective. But he undertakes
little comparative institutional analysis. What are the transaction costs
associated with commons-based peer production?
e book concludes with a section on public policy, summarizing Benkler’s
(2006, p. 25) concerns about privatizing the digital commons—what
he calls a “second enclosure movement”—and outlining a positive role
for the state, whose most important job, he argues, is to maintain openness,
or “neutrality,” within the economy’s digital infrastructure. Here,
as elsewhere, I find the treatment of government failure much too glib.
Information itself is not scarce, but, as noted earlier, is embodied in tangible
resources that are subject to the usual economic laws of supply and
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and calculation problems need to be treated in an appropriately comparative
manner, and Benkler does not do so. Despite these difficulties, e
Wealth of Networks is a useful guide to the networked information economy
and an eloquent statement of the left-liberal conception of the Internet’s
“institutional ecology.” Benkler clearly believes that social production is
more than a fad and has potentially revolutionary implications. I remain
unconvinced, but I feel better informed about the relevant issues after
reading Benkler’s book.
C Why Intellectuals Still Support Socialism †
Intellectuals, particularly academic intellectuals, tend to favor socialism
and interventionism. How was the American university transformed from
a center of higher learning to an outpost for socialist-inspired culture and
politics? As recently as the early 1950s, the typical American university
professor held social and political views quite similar to those of the general
population. Today—well, you’ve all heard the jokes that circulated after
the collapse of central planning in Eastern Europe and the former USSR,
how the only place in the world where Marxists were still thriving was the
Harvard political science department.
More generally, US higher education is now dominated by the students
who were radicalized in the 1960s and who have now risen to positions
of influence within colleges and universities. One needs only to
observe the aggressive pursuit of “diversity” in admissions and hiring, the
abandonment of the traditional curriculum in favor of highly politicized
“studies” based on group identity, the mandatory workshops on sensitivity
training, and so on. A 1989 study for the Carnegie Foundation for the
Advancement of Teaching used the categories “liberal” and “conservative.”
It found that 70 percent of the professors in the major liberal arts colleges
and research universities considered themselves liberal or moderately
liberal, with less than 20 percent identifying themselves as conservative
or moderately conservative (cited in Lee, 1994). (Of course, the term
“liberal” here means left-liberal or socialist, not classical liberal.)
† Published originally on Mises.org, November 16, 2006.

163
Cardiff and Klein (2005) examined academics’ political affiliations
using voter-registration records for tenure-track faculty at 11 California
universities. ey find an average Democrat:Republican ratio of 5:1,
ranging from 9:1 at Berkeley to 1:1 at Pepperdine. e humanities average
10:1, while business schools are at only 1.3:1. (Needless to say, even at
the heartless, dog-eat-dog, sycophant-of-the-bourgeoisie business schools
the ratio doesn’t dip below 1:1.) While today’s Republicans are hardly
anti-socialist—particularly on foreign policy—these figures are consistent
with a widespread perception that university faculties are increasingly unrepresentative
of the communities they supposedly serve.
Now here’s a surprise: even in economics, 63 percent of the faculty
in the Carnegie study identified themselves as liberal, compared with 72
percent in anthropology, political science, and sociology, 76 percent in
ethnic studies, history, and philosophy, and 88 percent in public affairs.
e Cardiff and Klein study finds an average D:R ratio in economics
departments of 2.8:1—lower than the sociologists’ 44:1, to be sure,
but higher than that of biological and chemical engineering, electrical
engineering, computer science, management, marketing, accounting, and
finance. A survey of American Economic Association members, examined
by Klein and Stern (2006), finds that most economists support
safety regulations, gun control, redistribution, public schooling, and antidiscrimination
laws. Another survey, reported in the Southern Economic
Journal, reveals that “71 percent of American economists believe the
distribution of income in the US should be more equal, and 81 percent
feel that the redistribution of income is a legitimate role for government.
Support for these positions is even stronger among economists with academic
affiliations, and stronger still among economists with elite academic
affiliations” (Lee, 1994, p. 21).
Why do so many university professors—and intellectuals more generally—favor
socialism and interventionism? F. A. Hayek offered a partial
explanation in his 1949 essay “e Intellectuals and Socialism.” Hayek
asked why “the more active, intelligent and original men among [American]
intellectuals . . . most frequently incline toward socialism.” His answer
is based on the opportunities available to people of varying talents.
Academics tend to be highly intelligent people. Given their leftward
leanings, one might be tempted to infer from this that more intelligent
people tend to favor socialism. However, this conclusion suffers from what

164
empirical researchers call “sample selection bias.” Intelligent people hold
a variety of views. Some are lovers of liberty, defenders of property, and
supporters of the “natural order”—i.e., defenders of the market. Others
are reformers, wanting to remake the world according to their own visions
of the ideal society. Hayek argues that exceptionally intelligent people who
favor the market tend to find opportunities for professional and financial
success outside the Academy (i.e., in the business or professional world).
ose who are highly intelligent but ill-disposed toward the market are
more likely to choose an academic career. For this reason, the universities
come to be filled with those intellectuals who were favorably disposed
toward socialism from the beginning.
is also leads to the phenomenon that academics don’t know much
about how markets work, since they have so little experience with them,
living as they do in their subsidized ivory towers and protected by academic
tenure. As Joseph Schumpeter explained in Capitalism, Socialism,
and Democracy (1942, p. 17), it is “the absence of direct responsibility for
practical affairs” that distinguishes the academic intellectual from others
“who wield the power of the spoken and the written word.” is absence of
direct responsibility leads to a corresponding absence of first-hand knowledge
of practical affairs. e critical attitude of the intellectual arises, says
Schumpeter, “no less from the intellectual’s situation as an onlooker—in
most cases also as an outsider—than from the fact that his main chance of
asserting himself lies in his actual or potential nuisance value.”
Hayek’s account is incomplete, however, because it doesn’t explain why
academics have become more and more interventionist throughout the
twentieth century. As mentioned above, during the first half of the twentieth
century university faculty members tended to hold political views
similar to those held by the general population. What caused the change?
To answer, we must realize first that academics receive many direct
benefits from the welfare state, and that these benefits have increased over
time. Excluding student financial aid, public universities receive about 50
percent of their funding from federal and state governments, dwarfing the
18 percent they receive from tuition and fees. Even “private” universities
like Stanford or Harvard receive around 20 percent of their budgets from
federal grants and contracts (US Department of Education, 1996). Including
student financial aid, the figure is almost 50 percent. According to the
US Department of Education, about a third of all students at public, 4-

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year colleges and universities, and half the students at private colleges and
universities, receive financial aid from the federal government.
In this sense, the most dramatic example of “corporate welfare” in the
US is the GI Bill, which subsidized the academic sector, bloating it far
beyond the level the market would have provided. e GI Bill, signed
by President Roosevelt in 1944 to send returning soldiers to colleges and
universities, cost taxpayers $14.5 billion between 1944 and 1956 (Skocpol,
1996). e latest (2008) version of the GI Bill is expected to cost $52
billion over the next ten years.
To see why this government aid is so important to the higher education
establishment, we need only stop to consider for a moment what academics
would do in a purely free society. e fact is that most academics simply
aren’t that important. In a free society, there would be far fewer of them
than there are today. eir public visibility would no doubt be quite low.
Most would be poorly paid. ough some would be engaged in scholarly
research, the vast majority would be teachers. eir job would be to pass
the collective wisdom of the ages along to the next generation. In all
likelihood, there would also be far fewer students. Some students would
attend traditional colleges and universities, but many more students would
attend technical and vocational schools, where their instructors would be
men and women with practical knowledge.
Today, many professors at major research universities do little teaching.
eir primary activity is research, though much of that is questionable as
real scholarship. One needs only to browse through the latest specialty
journals to see what passes for scholarly research in most disciplines. In the
humanities and social sciences, it is likely to be postmodern gobbledygook;
in the professional schools, vocationally oriented technical reports. Much
of this research is funded in the United States by government agencies,
such as the National Science Foundation, National Institutes of Health,
the National Endowment for the Humanities, the USDA, and others. e
large universities have tens of thousands of students, themselves supported
by government-subsidized loans and grants.
Beyond university life, academics also compete for prestigious posts
within government agencies. Consider economics. e US federal government
employs at least 3,000 economists—about 15% of all members
of the American Economic Association. e Federal Reserve System itself
employs several hundred. ere are also advisory posts, affiliations

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with important government agencies, memberships of federally appointed
commissions, and other career-enhancing activities. ese benefits are not
simply financial. ey are also psychological. As Lee (1994, p. 22) puts it:
Like every other group, academics like to exert influence and feel
important. Few scholars in the social sciences and humanities are
content just to observe, describe, and explain society; most want
to improve society and are naive enough to believe that they could
do so if only they had sufficient influence. e existence of a huge
government offers academics the real possibility of living out their
reformist fantasies. 1
It’s clear, then, that for academics, there are many benefits to living
in a highly interventionist society. It should be no wonder, then, that
academics tend to support those interventions. Economists, in particular,
play active roles as government advisers, creating and sustaining the welfare
state that now surrounds us. Naturally, when government funds their
research, economists in applied fields such as agricultural economics and
monetary economics are unlikely to call for serious regulatory reform in
their specialty areas.
Murray Rothbard devotes an interesting chapter of Man, Economy,
and State, to the traditional role of the economist in public life. Rothbard
notes that the functions of the economist on the free market differ strongly
from those of the economist on the hampered market. “What can the
economist do on the purely free market?” Rothbard asks. “He can explain
the workings of the market economy (a vital task, especially since the
untutored person tends to regard the market economy as sheer chaos), but
he can do little else.”
Furthermore, economists are not traditionally popular as policy advisors.
Economics teaches that resources are limited, that choices made
imply opportunities forgone, that our actions can have unintended consequences.
is is typically not what government officials want to hear.
When they propose an import tariff to help domestic manufacturers, we
economists explain that this protection will come only at the expense of
domestic consumers. When they suggest a minimum-wage law to raise the
incomes of low-wage workers, we show that such a law hurts the very people
it purports to help by forcing them out of work. Over the last several
1 See also Pasour (2004) and White (2005) on the influence of government spending
on research in agricultural economics and monetary economics, respectively.

167
decades, however, the role of the economist has expanded dramatically.
Partly for the reasons we discussed earlier, the welfare state has partly coopted
the profession of economics. Just as a higher murder rate increases
the demand for criminologists, so the growth of the welfare/regulatory
state increases the demand for policy analysts, antitrust consultants, tax
and regulatory experts, and various forecasters.
To some degree, the increasing professionalization of the economics
business must share the blame for this change. e economists’ premier
professional society, the American Economic Association, was itself created
as an explicitly “progressive” organization. Its founder, the religious and
social reformer Richard T. Ely, planned an association, he reported to a
colleague, of “economists who repudiate laissez-faire as a scientific doctrine”
(Coats, 1960, p. 556). e other founding members, all of whom
had been trained in Germany under Gustav Schmoller and other members
of the younger German Historical School—the so-called Socialists of the
Chair—were similarly possessed with reformist zeal. e constitution of
the AEA still contains references to the “positive role of the church, the
state and science in the solution of social problems by the development
of legislative policy” (Coats, 1960, p. 558). Fortunately, the AEA subsequently
distanced itself from the aims of its founders, although its annual
distinguished lecture is still called the “Richard T. Ely lecture.” 2
If asked to select a single event that most encouraged the transformation
of the average economist from a critic of intervention to a defender
of the welfare state, I would name the Second World War. To be sure,
it was the Progressive Era that saw the permanent introduction of the
income tax and the establishment of the Federal Reserve System. And
it was during the Great Depression that Washington, D.C., first began to
employ a substantial number of economists to join such central planning
organizations as the National Resources Planning Board. Still, even in
those years, the average economist favored free trade, low taxes, and sound
money.
World War II, however, was a watershed event for the profession. For
the first time, professional economists joined the ranks of government
planning bureaus en masse. One job was to control prices, as with the
Office of Price Administration, led by Leon Henderson and later John
2 For more on the professionalization of economics see Bernstein (2001).

168
Kenneth Galbraith. is group included prominent free-market economists
such as Herbert Stein and George Stigler. Another role was to study
military procurement (what later became known as “operations research”)
with Columbia University’s Statistical Research Group (including Stigler,
Milton Friedman, Harold Hotelling, Abraham Wald, Leonard Savage), or
with the Army’s Statistical Control Group, which was led by Tex ornton,
later president of Litton Industries, and his “Whiz Kids.” e most famous
Whiz Kid was Robert McNamara, ornton’s leading protégé, who later
applied the same techniques to the management of the Vietnam War. 3
Moreover, before World War II the primary language of economics, in
the English-speaking world, was English. Since then, however, economic
theory has come to be expressed in obscure mathematical jargon, while
economic history has become a branch of applied statistics. It is common
to attribute this change to the publication of Paul Samuelson’s mathematical
treatise (Samuelson, 1947), and to the development of computers.
ese are no doubt important. However, it is likely the taste for central
planning that economists—even nominally free-market economists—got
during World War II that forever changed the direction of the discipline.
What about other public figures, what Hayek called “second-hand
dealers in ideas”—the journalists, book editors, high-school teachers, and
other members of the “opinion-molding” class? First, intelligent and articulate
liberals (in the classical sense) tend to go into business and the
professions (Hayek’s selection-bias argument). Second, many journalists
trade integrity for access; few are brave enough to challenge the state,
because they crave information, interviews, and time with state officials.
What does the future hold? It is impossible to say for sure, but there are
encouraging signs. e main reason is technology. e web has challenged
the state university and state media cartels as never before. You don’t need
a PhD to write for Wikipedia. What does the rise of the new media, new
means of sharing information, new ways of establishing authority and credibility,
imply for universities as credential factories? Moreover, as universities
become more vocationally oriented, they will find it hard to compete
with specialized, technology-intensive institutions such as DeVry University
and the University of Phoenix, the fastest-growing US universities.
3 On Litton see also Sobel (1984, pp. 68–72). On the relationship between ornton
and McNamara see Shapley (1993) and Byrne (1993).

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e current crises in higher education and the media are probably
good things, in the long run, if they force a rethinking of educational and
intellectual goals and objectives, and take power away from the establishment
institutions. en, and only then, we may see a rebirth of genuine
scholarship, communication, and education.
D Management Theory and the Business Cycle †
(with Nicolai J. Foss)
Is management theory to blame for the current crisis in the world economy?
Some commentators think that business schools’ focus on shareholder
wealth maximization, performance-based pay, and the virtue of
self-interest have led banks, corporations, and governments astray. Hefty
bonuses promoted excessive risk-taking, and the free-market philosophy
taught in business schools removed the final ethical checks and balances
on such behavior. “It is the type of thinking,” worry Raymond Fisman and
Rakesh Khurana (2008), “that is now bringing capitalism to its knees.”
e populist crackdown on executive pay is linked to such thinking.
e late Sumantra Ghoshal of the London Business School, widely hailed
as one of the world’s foremost management gurus, was a forceful critic of
performance pay and its allegedly destructive consequences. More generally,
Ghoshal thought that management theory was “bad for practice”
financially, ethically, and politically Ghoshal and Moran (1996); Ghoshal
(2005).
We think, however, that management theory has much to offer policymakers,
practitioners, and analysts seeking to understand the current crisis.
Take, for example, the notion of heterogeneity. e idea that resources,
firms, and industries are different from each other—that capital and labor
are specialized for particular projects and activities, that people are
distinct—is ubiquitous in the theory and practice of management. What
strategists call competitive advantage arises from heterogeneity, from doing
something differently from the competition. Human-resource managers
† Published originally as “Management eory is Not to Blame,” Mises.org, March 19,
2009. See also Agarwal, Barney, Foss, and Klein (2009) for further details.

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deal with an increasingly diverse workforce and people with highly specialized
talents. Firms that expand internationally learn the lessons of market,
cultural, and institutional heterogeneity. As a consequence, management
scholars think of firms as bundles of heterogeneous resources or assets.
Assets can be specific to certain firms. Assets may be “co-specialized” with
other assets, such that they generate value only in certain combinations.
And as any accountant knows, assets have different (economic) life expectancies.
Such unique and specialized assets can also be intangible, such
as worker-specific knowledge or firm-specific capabilities.
To the uninitiated this may sound trite. But look at economics. Here
homogeneity, not heterogeneity, rules the roost. Economic models of industries
and economies typically start with “representative firms,” implying
that all firms in an industry are alike. is may be a handy starting point if
one is interested in the industry per se rather than in individual firms, but
can be seriously misleading if one is interested in the relative performance
of firms or industries.
And, here, macroeconomists are the worst transgressors. eir models
of an entire economy treat factors of production as homogeneous within
categories. us, “labor” means homogeneous labor inputs. “Capital” has
the same interpretation. Nobel Laureate Robert Solow adopted the notion
of “shmoo” from the comic Lil’ Abner—shmoos are identical creatures
shaped like bowling pins with legs—to capture this kind of homogeneity.
is style of reasoning originated with Ricardo, who found it a useful
simplification. And it can be. But sometimes economists’ assumption of
homogeneity leads them into trouble, as is the case with the current crisis.
e macroeconomic problem, we are told, is that “banks” made unwise
investments, and now aren’t “lending” enough. “Businesses” and “consumers”
can’t get “loans.” “Firms” have too many “bad assets” on their
books. e key question, though, is which ones? Which banks aren’t lending
to which customers? Which firms have made poor investments? A loan
isn’t a loan isn’t a loan. e relevant question, in analyzing the credit mess,
is which loans aren’t being made, to whom, and why? e critical issues are
the composition of lending, not the amount. Total lending, total liquidity,
average equity prices, and the like obscure the key questions about how
resources are being allocated across sectors, firms, and individuals, whether
bad investments are being liquidated, and so on. Such aggregate notions
homogenize—and in doing so, suppress critical information about relative

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prices. e main function of capital markets, after all, is not to moderate
the total amount of financial capital, but to allocate capital across activities.
e US stimulus package and similar proposals around the world are
likewise stymied by their crude, Keynesian-style reliance on macroeconomic
aggregates. According to the common wisdom, the bank crisis led
to a collapse of effective aggregate demand, and only massive increases in
government expenditure (and government debt) can kick-start the economy.
Expenditures—on what? It doesn’t matter: just spend. e only
criterion is whether the projects are “shovel-ready.”
But a shovel isn’t a shovel isn’t a shovel. As Hayek—Keynes’s most
important intellectual opponent—argued in the 1930s and 1940s, the
economy’s capital structure is a complex and delicate structure, one that
cannot be mashed and pushed like putty. Resources cannot be shifted
costlessly from one activity to another, particularly in a modern economy
in which much of those resources are embodied in industry-specific,
firm-specific, and worker-specific capabilities. Even idle resources can be
misallocated—what Hayek and Mises called “malinvestment”—if invested
in activities that don’t produce the goods and services the economy needs.
Every manager knows that directing specialized resources to the wrong
projects is a bad bet, even if it leads to a slight boost in short-term earnings.
In the same way, the path to economic recovery is to allow markets to
channel specialized resources to their highest-valued uses, not to dump
taxpayer funds on whatever firms and industries happen to be ready for
them—or politically connected. In an important sense, banks’ failure
to distinguish among heterogeneous borrowers got us into this mess. A
mistaken focus on homogeneity, in pursuit of a quick fix, will only bring
more of the same.
E Menger the Revolutionary †
“ere never lived at the same time,” wrote Ludwig von Mises (1949,
p. 869), “more than a score of men whose work contributed anything
essential to economics.” One of those men was Carl Menger (1840–1921),
† Published originally as the Foreword to Carl Menger, Principles of Economics (reprint
edition, Auburn, Ala.: Ludwig von Mises Institute, 2006).

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Professor of Political Economy at the University of Vienna and founder
of the Austrian school of economics. Menger’s path-breaking Grundsätze
der Volkswirtschaftslehre [Principles of Economics], published in 1871, not
only introduced the concept of marginal analysis, it presented a radically
new approach to economic analysis, one that still forms the core of the
Austrian theory of value and price.
Unlike his contemporaries William Stanley Jevons and Léon Walras,
who independently developed concepts of marginal utility during the
1870s, Menger favored an approach that was deductive, teleological,
and, in a fundamental sense, humanistic. While Menger shared his
contemporaries’ preference for abstract reasoning, he was primarily interested
in explaining the real-world actions of real people, not in creating
artificial, stylized representations of reality. Economics, for Menger, is the
study of purposeful human choice, the relationship between means and
ends. “All things are subject to the law of cause and effect,” he begins
his treatise. “is great principle knows no exception” (Menger, 1871,
p. 51). Jevons and Walras rejected cause and effect in favor of simultaneous
determination, the idea that complex systems can be modeled as
systems of simultaneous equations in which no variable can be said to
“cause” another. is has become the standard approach in contemporary
economics, accepted by nearly all economists but the followers of Menger.
Menger sought to explain prices as the outcome of the purposeful, voluntary
interactions of buyers and sellers, each guided by their own, subjective
evaluations of the usefulness of various goods and services in satisfying
their objectives (what we now call marginal utility, a term later coined
by Friedrich von Wieser). Trade is thus the result of people’s deliberate
attempts to improve their well-being, not an innate “propensity to truck,
barter, and exchange,” as suggested by Adam Smith (1776, I, p. 24). e
exact quantities of goods exchanged—their prices, in other words—are
determined by the values individuals attach to marginal units of these
goods. With a single buyer and seller, goods are exchanged as long as
participants can agree on an exchange ratio that leaves each better off than
he was before.
In a market with many buyers and sellers, the price reflects the valuations
of the buyer least willing to buy and the seller least willing to sell,
what Böhm-Bawerk would call the “marginal pairs.” With each voluntary
exchange, then, the gains from trade are momentarily exhausted, regardless

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of the exact structure of the market. Menger’s highly general explanation
of price formation continues to form the core of Austrian microeconomics.
Menger’s analysis has been labeled “causal-realistic,” partly to emphasize
the distinction between Menger’s approach and that of the neoclassical
economists (see chapter 7 for a detailed discussion of Menger’s economic
theory). Besides its focus on causal relations, Menger’s analysis is realistic in
the sense that he sought not to develop formal models of hypothetical economic
relationships, but to explain the actual prices paid every day in real
markets. e classical economists had explained that prices are the result
of supply and demand, but they lacked a satisfactory theory of valuation to
explain buyers’ willingness to pay for goods and services. Rejecting value
subjectivism, the classical economists tended to treat demand as relatively
unimportant and concentrated on hypothetical “long-run” conditions, in
which “objective” characteristics of goods—most importantly, their costs
of production—would determine their prices. e classical economists
also tended to group factors of production into broad categories—land,
labor, and capital—leaving them unable to explain the prices of discrete,
heterogeneous units of these factors. Menger realized that the actual prices
paid for goods and services reflect not some objective, “intrinsic” characteristics,
but rather the uses to which discrete units of goods and services
can be put as perceived, subjectively, by individual buyers and sellers.
e Principles was written as an introductory volume in a proposed
multi-volume work. As noted in chapter 7 above, however, no later volumes
were written. Menger did not in the Principles develop explicitly
the concept of opportunity cost, he did not extend his analysis to explain
the prices of the factors of production, and he did not develop a theory
of monetary calculation. ose advances would come later from his students
and disciples Böhm-Bawerk, Wieser, J. B. Clark, Wicksteed, Fetter,
Davenport, Mises, and Hayek. Many of the most important ideas are
implicit in Menger’s analysis, however. For example, his distinction among
goods of lower and higher “orders,” referring to their place in the temporal
sequence of production, forms the heart of Austrian capital theory, one of
its most distinctive and important elements. Indeed, Menger emphasizes
the passage of time throughout his analysis, an emphasis that has not yet
made its way into mainstream economic theorizing.
While most contemporary economics treatises are turgid and dull,
Menger’s book is remarkably easy to read, even today. His prose is lucid,

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his analysis is logical and systematic, his examples clear and informative.
e Principles remains an excellent introduction to economic reasoning
and, for the specialist, the classic statement of the core principles of the
Austrian school.
As Hayek (1976, p. 12) writes, the significance of the Austrian school
is “entirely due to the foundations laid by this one man.” However, while
Menger is universally recognized as the Austrian school’s founder, his
causal-realistic approach to price formation is not always appreciated, even
within contemporary Austrian economics. As we saw in chapter 7, Vaughn
(1994) finds Menger’s price theory unoriginal, identifying as the distinctive
“Austrian” contribution in Menger his brief references to institutions,
evolution, and the like. My view is different: Menger’s main contribution
to the Austrian tradition is his price theory, his “mundane” economics,
which is distinct from that of the neoclassical tradition and which is the
fundamental building block of Austrian economic analysis.
Another remarkable feature of Menger’s contribution is that it appeared
in German, while the then-dominant approach in the Germanspeaking
world was that of the “younger” German historical school, which
eschewed theoretical analysis altogether in favor of inductive, ideologically
driven, historical case studies. e most accomplished theoretical economists,
the British classicals such as J. S. Mill, were largely unknown to
German-speaking writers. As Hayek (1976, p. 13) notes, “[i]n England
the progress of economic theory only stagnated. In Germany a second
generation of historical economists grew up who had not only never become
really acquainted with the one well-developed system of theory that
existed, but had also learnt to regard theoretical speculations of any sort as
useless if not positively harmful.” Menger’s approach—haughtily dismissed
by the leader of the German historical school, Gustav Schmoller, as merely
“Austrian,” the origin of that label—led to a renaissance of theoretical
economics in Europe and, later, in the US.
In short, the core concepts of contemporary Austrian economics—human
action, means and ends, subjective value, marginal analysis, methodological
individualism, the time structure of production, and so on—along
with the Austrian theory of value and price, which forms the heart of
Austrian analysis, all flow from Menger’s pathbreaking work. As Salerno
(1999a, p. 71) has written, “Austrian economics always was and will forever
remain Mengerian economics.”

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F Hayek the Innovator †
F. A. Hayek is undoubtedly the most eminent of the modern Austrian
economists. Student of Friedrich von Wieser, protégé and colleague
of Mises, and foremost representative of an outstanding generation of
Austrian school theorists, Hayek was more successful than anyone else in
spreading Austrian ideas throughout the English-speaking world. “When
the definitive history of economic analysis during the 1930s comes to be
written,” said John Hicks in 1967, “a leading character in the drama (it was
quite a drama) will be Professor Hayek.... [I]t is hardly remembered that
there was a time when the new theories of Hayek were the principal rival of
the new theories of Keynes” (Hicks, 1967, p. 203). Unfortunately, Hayek’s
theory of the business cycle was eventually swept aside by the Keynesian
revolution. Ultimately, however, this work was again recognized when
Hayek received, along with the Swede Gunnar Myrdal, the 1974 Nobel
Memorial Prize in Economic Science. Hayek was a prolific writer over
nearly seven decades; his Collected Works, currently being published by
the University of Chicago Press and Routledge, are projected at nineteen
volumes.
Life and work
Hayek’s life spanned the twentieth century, and he made his home in some
of the great intellectual communities of the period. 4 Born Friedrich August
von Hayek in 1899 to a distinguished family of Viennese intellectuals, 5
Hayek attended the University of Vienna, earning doctorates in 1921 and
1923. Hayek came to the University at age 19 just after World War I, when
it was one of the three best places in the world to study economics (the others
being Stockholm and Cambridge, England). ough he was enrolled
as a law student, his primary interests were economics and psychology,
the latter due to the influence of Mach’s theory of perception on Wieser
† Published originally as “F. A. Hayek: Austrian Economist and Social eorist,”
in Randall G. Holcombe, ed., Fifteen Great Austrian Economists. Auburn, Ala.: Mises
Institute, 1999, pp. 181–94.
4 Hayek (1994), and the introduction by Stephen Kresge.
5 Hayek’s father was a physician and botanist. One grandfather, a statistician, was a
friend of Eugen von Böhm-Bawerk; the philosopher Ludwig Wittgenstein was a second
cousin.

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and Wieser’s colleague Othmar Spann, and the former stemming from the
reformist ideal of Fabian socialism so typical of Hayek’s generation.
Like many students of economics then and since, Hayek chose the
subject not for its own sake, but because he wanted to improve social
conditions—the poverty of postwar Vienna serving as a daily reminder
of such a need. Socialism seemed to provide a solution. en in 1922
Mises published his Die Gemeinwirtschaft, later translated as Socialism.
“To none of us young men who read the book when it appeared,” Hayek
recalled, “the world was ever the same again” (Hayek, 1956, p. 133). Socialism,
an elaboration of Mises’s pioneering article from two years before,
argued that economic calculation requires a market for the means
of production; without such a market there is no way to establish the
values of those means and, consequently, no way to find their proper uses
in production. Mises’s devastating attack on central planning converted
Hayek to laissez-faire, along with contemporaries like Wilhelm Röpke,
Lionel Robbins, and Bertil Ohlin. It was around this time that Hayek
began attending Mises’s famed Privatseminar. Regular participants, who
received no academic credit or other official recognition for their time,
included Hayek, Gottfried Haberler, Fritz Machlup, Oskar Morgenstern,
Paul Rosenstein-Rodan, Richard von Strigl, Karl Schlesinger, Felix Kaufmann,
Alfred Schütz, Eric Voegelin, Karl Menger, Jr., and others not so
famous. For several years the Privatseminar was the center of the economics
community in Vienna, attracting such visitors as Robbins from London
and Howard S. Ellis from Berkeley. Later, Hayek became the first of this
group to leave Vienna; most of the others, along with Mises himself, were
also gone by the start of World War II.
Mises had done earlier work on monetary and banking theory, successfully
applying the Austrian marginal utility principle to the value of
money and then sketching a theory of industrial fluctuations based on
the doctrines of the British Currency School and the ideas of the Swedish
economist Knut Wicksell. Hayek used this last as a starting point for
his own research on fluctuations, explaining the origin of the business
cycle in terms of bank credit expansion and its transmission in terms of
capital malinvestments. His work in this area eventually earned him an
invitation to lecture at the London School of Economics and Political
Science and then to occupy its Tooke Chair in Economics and Statistics,
which he accepted in 1931. ere he found himself among a vibrant and

177
exciting group: Robbins, J. R. Hicks, Arnold Plant, Dennis Robertson,
T. E. Gregory, Abba Lerner, Kenneth Boulding, and George Shackle, to
name only the most prominent. Hayek brought his (to them) unfamiliar
views, 6 and gradually, the “Austrian” theory of the business cycle became
known and accepted. At the LSE Hayek lectured on Mises’s business-cycle
theory, which he was refining and which, until Keynes’s General eory
came out in 1936, was rapidly gaining adherents in Britain and the US
and was becoming the preferred explanation of the Depression. Hayek and
Keynes had sparred in the early 1930s in the pages of the Economic Journal
over Keynes’s Treatise on Money. As one of Keynes’s leading professional
adversaries, Hayek was well situated to provide a full refutation of the
General eory. But he never did. Part of the explanation for this no doubt
lies with Keynes’s personal charm and legendary rhetorical skill, along with
Hayek’s general reluctance to engage in direct confrontation with his colleagues.
7 Hayek also considered Keynes an ally in the fight against wartime
inflation and did not want to detract from that issue (Hayek, 1994, p. 91).
Furthermore, as Hayek later explained, Keynes was constantly changing his
theoretical framework, and Hayek saw no point in working out a detailed
critique of the General eory, if Keynes might change his mind again
(Hayek, 1963b, p. 60; Hayek, 1966, pp. 240–41). Hayek thought a better
course would be to produce a fuller elaboration of Böhm-Bawerk’s capital
theory, and he began to devote his energies to this project. Unfortunately,
e Pure eory of Capital was not completed until 1941, and by then the
Keynesian macro model had become firmly established. 8
Within a very few years, however, the fortunes of the Austrian school
6 Hicks (1967, p. 204) noted, in reference to Hayek’s first (1931) English book, that
“Prices and Production was in English, but it was not English economics.”
7 In addition, Hayek (1963b, p. 60) cited his own “tiredness from controversy”; he had
already engaged the market socialists on economic calculation, Knight on capital theory,
and Keynes on money.
8 For more on Hayek’s failure to respond to the General eory see Caldwell (1995),
especially pp. 40–6. Hayek (1963b, pp. 60–61; 1966, pp. 240–41) also believed that an
effective refutation of Keynes would have to begin with a thorough critique of aggregate,
or “macro” economics more generally. Caldwell (1988) suggests another reason: it was
during this time that Hayek was losing faith in equilibrium theory and moving toward a
“market process” view of economic activity, making it difficult for him to engage Keynes
on the same terms in which they had debated earlier. McCormick (1992, pp. 99–134)
and Blaug (1993, pp. 53–55) propose an entirely different reason: Hayek couldn’t respond
because the Austrian capital theory, on which the cycle theory was built, was simply wrong.

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suffered a dramatic reversal. First, the Austrian theory of capital, an integral
part of the business-cycle theory, came under attack from the Italianborn
Cambridge economist Piero Sraffa and the American Frank Knight,
while the cycle theory itself was forgotten amid the enthusiasm for the
General eory. Second, beginning with Hayek’s move to London and
continuing until the early 1940s, the Austrian economists left Vienna for
personal and then for political reasons, so that a school ceased to exist
there as such. 9 Mises left Vienna in 1934 for Geneva and then New York,
where he continued to work in isolation; Hayek remained at the LSE until
1950, when he joined the Committee on Social ought at the University
of Chicago. Other Austrians of Hayek’s generation became prominent in
the US—Gottfried Haberler at Harvard, Fritz Machlup and Oskar Morgenstern
at Princeton, Paul Rosenstein-Rodan at MIT—but their work no
longer seemed to show distinct traces of the tradition founded by Menger.
At Chicago, Hayek again found himself among a dazzling group: the
economics department, led by Knight, Milton Friedman, and later George
Stigler, was one of the best anywhere, and Aaron Director at the law school
soon set up the first law and economics program. 10 But economic theory,
in particular its style of reasoning, was rapidly changing; Paul Samuelson’s
Foundations had appeared in 1947, establishing physics as the science for
economics to imitate, and Friedman’s 1953 essay on “positive economics”
set a new standard for economic method. In addition, Hayek had ceased
to work on economic theory, concentrating instead on psychology, philosophy,
and politics, and Austrian economics entered a prolonged eclipse. 11
Important work in the Austrian tradition was done during this period
by Rothbard (1956, 1962, 1963a,b), Kirzner (1963, 1966, 1973), and
Lachmann (1956), but at least publicly, the Austrian tradition lay mostly
dormant.
9 On the emigration of the Austrian economists see Craver (1986).
10 However, at Chicago Hayek was considered something of an outsider; his post was
with the Committee on Social ought, not the economics department, and his salary was
paid by a private foundation, the William Volker Fund (the same organization that paid
Mises’s salary as a visiting professor at New York University).
11 By this time, Hayek (1994, p. 126) said, “I had . .. become somewhat stale as an
economist and felt much out of sympathy with the direction in which economics was
developing. ough I had still regarded the work I had done during the 1940s on scientific
method, the history of ideas, and political theory as temporary excursions into another
field, I found it difficult to return to systematic teaching of economic theory and felt it
rather as a release that I was not forced to do so by my teaching duties.”

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When the 1974 Nobel Prize in economics went to Hayek, interest in
the Austrian school was suddenly and unexpectedly revived. While this
was not the first event of the so-called “Austrian revival,” the memorable
South Royalton conference having taken place earlier the same year, the
rediscovery of Hayek by the economics profession was nonetheless a decisive
event in the renaissance of Austrian economics. 12 Hayek’s writings
were taught to new generations, and Hayek himself appeared at the early
Institute for Humane Studies conferences in the mid-1970s. He continued
to write, producing e Fatal Conceit in 1988, at the age of 89. Hayek died
in 1992 in Freiburg, Germany, where he had lived since leaving Chicago
in 1961.
Contributions to economics
Hayek’s legacy in economics is complex. Among mainstream economists,
he is mainly known for his popular e Road to Serfdom (1944) and for his
work on knowledge in the 1930s and 1940s (Hayek, 1937, 1945). Specialists
in business-cycle theory recognize his early work on industrial fluctuations,
and modern information theorists often acknowledge Hayek’s
work on prices as signals, although his conclusions are typically disputed. 13
Hayek’s work is also known in political philosophy (Hayek, 1960), legal
theory (Hayek, 1973–79), and psychology (Hayek, 1952b). Within
the Austrian school of economics, Hayek’s influence, while undeniably
12 e proceedings of the South Royalton conference were published as e Foundations
of Modern Austrian Economics (Dolan, 1976). A follow-up volume appeared two years
later: New Directions in Austrian Economics (Spadaro, 1978). For perspectives on the
Austrian revival see Rothbard (1995), and Vaughn (1994). Salerno (1996b) argues that
the Austrian revival should be dated not from 1974, but from 1962–63, when Rothbard
published Man, Economy, and State (1962), America’s Great Depression (1963a), and What
Has Government Done to Our Money? (1963b), the works that sparked the younger South
Royalton participants’ interest in Austrian economics.
13 Lucas (1977) cites Hayek as a leading exponent of pre-Keynesian business-cycle theory.
Grossman and Stiglitz (1976) and Grossman (1980; 1989) argue that contrary to
Hayek, market prices are not “sufficient statistics” for changes in tastes and technology.
is literature tries to test the “informative content” of price signals, and contends that
in general only perfectly competitive prices convey useful information. Farrell and Bolton
(1990) claim that Hayek overstates the coordinating properties of decentralized market
exchange. Hayek’s 1945 paper is also frequently cited in the new institutional literature
emphasizing process and adaptation, although coordination through markets is seen as
only one type of desirable coordination. See, for example, Williamson (1991c).

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immense, has very recently become the subject of some controversy. His
emphasis on spontaneous order and his work on complex systems have
been widely influential among many Austrians. Others have preferred to
stress Hayek’s work in technical economics, particularly on capital and the
business cycle, citing a tension between some of Hayek’s and Mises’s views
on the social order. (While Mises was a rationalist and a utilitarian, Hayek
focused on the limits to reason, basing his defense of capitalism on its
ability to use limited knowledge and learning by trial and error.)
BUSINESS-CYCLE THEORY. Hayek’s writings on capital, money, and the
business cycle are widely regarded as his most important contributions to
economics (Hicks, 1967; Machlup, 1976b). Building on Mises’s eory of
Money and Credit (1912), Hayek showed how fluctuations in economywide
output and employment are related to the economy’s capital structure.
In Prices and Production (1931) he introduced the famous “Hayekian
triangles” to illustrate the relationship between the value of capital goods
and their place in the temporal sequence of production. Because production
takes time, factors of production must be committed in the present
for making final goods that will have value only in the future after they
are sold. However, capital is heterogeneous. As capital goods are used
in production, they are transformed from general-purpose materials and
components to intermediate products specific to particular final goods.
Consequently, these assets cannot be easily redeployed to alternative uses
if demands for final goods change. e central macroeconomic problem in
a modern capital-using economy is thus one of intertemporal coordination:
how can the allocation of resources between capital and consumer goods be
aligned with consumers’ preferences between present and future consumption?
In e Pure eory of Capital (1941), perhaps his most ambitious
work, Hayek describes how the economy’s structure of production depends
on the characteristics of capital goods—durability, complementarity, substitutability,
specificity, and so on. is structure can be described by the
various “investment periods” of inputs, an extension of Böhm-Bawerk’s
notion of “roundaboutness,” the degree to which production takes up resources
over time. 14
14 Hayek ultimately rejected Böhm-Bawerk’s “average period of production” as a useful
concept, though he had used it earlier in Prices and Production (1931). See Hayek (1994),
p. 141, and White (1996)

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In Prices and Production (1931) and Monetary eory and the Trade
Cycle (1933b) Hayek showed how monetary injections, by lowering the
rate of interest below what Mises (following Wicksell) called its “natural
rate,” distort the economy’s intertemporal structure of production. 15 Most
theories of the effects of money on prices and output (then and since)
consider only the effects of the total money supply on the price level and aggregate
output or investment. e Austrian theory, as developed by Mises
and Hayek, focuses on the way money enters the economy (“injection
effects”) and how this affects relative prices and investment in particular
sectors. In Hayek’s framework, investments in some stages of production
are “malinvestments” if they do not help to align the structure of production
to consumers’ intertemporal preferences. e reduction in interest
rates caused by credit expansion directs resources toward capital-intensive
processes and early stages of production (whose investment demands are
more interest-rate elastic), thus “lengthening” the period of production. If
interest rates had fallen because consumers had changed their preferences
to favor future over present consumption, then the longer time structure
of production would have been an appropriate, coordinating response.
A fall in interest rates caused by credit expansion, however, would have
been a “false signal,” causing changes in the structure of production that
do not accord with consumers’ intertemporal preferences. 16 e boom
generated by the increase in investment is artificial. Eventually, market
participants come to realize that there are not enough savings to complete
all the new projects; the boom becomes a bust as these malinvestments
are discovered and liquidated. 17 Every artificial boom induced by credit
15 Hayek thought the more important case was when the market interest rate was kept
constant despite a rise in the natural interest rate. In his writings, however, he focused on
the expositionally easier case when credit expansion lowers the market interest rate below
an unchanged natural rate.
16 For most of his career Hayek viewed a system of fractional-reserve banking as inherently
unstable, endorsing a role (in principle) for government stabilization of the money
supply. In later writings, beginning with e Constitution of Liberty (1960) and culminating
in Denationalisation of Money (1976), he argued in favor of competition among private
issuers of fiat money. See White (1999).
17 Anticipating modern cycle theories, Hayek (1939b) recognized that the behavior of
the cycle depends on expectations about future price and interest rate movements. As
Garrison and Kirzner put it (1987, p. 612), for Hayek “prices are signals, not marching
orders.” But Hayek did not believe agents could know the real structure of the economy,
to correctly distinguish movements in interest rates generated by changes in consumers’

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expansion, then, is self-reversing. Recovery consists of liquidating the malinvestments
induced by the lowering of interest rates below their natural
levels, thus restoring the time structure of production so that it accords
with consumers’ intertemporal preferences. 18
KNOWLEDGE, PRICES, AND COMPETITION AS A DISCOVERY PROCEDURE.
Hayek’s writings on dispersed knowledge and spontaneous order are also
widely known, but more controversial. In “Economics and Knowledge”
(1937) and “e Use of Knowledge in Society” (1945) Hayek argued
that the central economic problem facing society is not, as is commonly
expressed in textbooks, the allocation of given resources among competing
ends. “It is rather a problem of how to secure the best use of resources
known to any of the members of society, for ends whose relative importance
only those individuals know. Or, to put it briefly, it is a problem of
the utilization of knowledge not given to anyone in its totality” (Hayek,
1945, p. 78).
Much of the knowledge necessary for running the economic system,
Hayek contended, is in the form not of “scientific” or technical knowledge—the
conscious awareness of the rules governing natural and social
phenomena—but of “tacit” knowledge, the idiosyncratic, dispersed bits of
understanding of “circumstances of time and place.” is tacit knowledge
is often not consciously known even to those who possess it and can never
be communicated to a central authority. e market tends to use this
tacit knowledge through a type of “discovery procedure” (Hayek, 1968b),
by which this information is unknowingly transmitted throughout the
economy as an unintended consequence of individuals’ pursuing their own
ends. 19 Indeed, Hayek’s (1948) distinction between the neoclassical nointertemporal
preferences from those generated by changes in the money supply.
18 For general overviews of Hayek’s macroeconomic views see O’Driscoll (1977), and
Garrison and Kirzner (1987). For expositions and interpretations of the Austrian tradecycle
theory, particularly as it relates to modern cycle theories, see Garrison (1978, 2000);
Beilante and Garrison (1988); van Zijp (1993); and Foss (1994b), pp. 39–55.
19 Hayek’s use of an argument from ignorance as a defense of the market is unusual.
Modern economists typically require assumptions of hyperrationality—complete and perfect
information, rational expectations, perfect markets, and so on—to justify market allocations
as “efficient.” In the new microeconomics literature on information and incentives,
theorists like Joseph Stiglitz have used deviations from these assumptions of perfection to

183
tion of “competition,” identified as a set of equilibrium conditions (number
of market participants, characteristics of the product, and so on), and
the older notion of competition as a rivalrous process, has been widely
influential in Austrian economics (Kirzner, 1973; Machovec, 1995).
For Hayek, market competition generates a particular kind of order—
an order that is the product “of human action but not human design” (a
phrase Hayek borrowed from Adam Smith’s mentor Adam Ferguson). is
“spontaneous order” is a system that comes about through the independent
actions of many individuals, and produces overall benefits unintended and
mostly unforeseen by those whose actions bring it about. To distinguish
between this kind of order and that of a deliberate, planned system, Hayek
(1968c) used the Greek terms cosmos for a spontaneous order and taxis
for a consciously planned one. 20 Examples of a cosmos include the market
system as a whole, money, the common law, and even language. A taxis, by
contrast, is a designed or constructed organization, like a firm or bureau;
these are the “islands of conscious power in [the] ocean of unconscious
cooperation like lumps of butter coagulating in a pail of buttermilk” (D. H.
Robertson, quoted in Coase, 1937, p. 35). 21
Most commentators view Hayek’s work on knowledge, discovery, and
competition as an outgrowth of his participation in the socialist calculation
debate of the 1920s and 1930s. e socialists erred, in Hayek’s view, in
failing to see that the economy as a whole is necessarily a spontaneous order
and can never be deliberately made over in the way that the operators of a
planned order can exercise control over their organization. is is because
planned orders can handle only problems of strictly limited complexity.
Spontaneous orders, by contrast, tend to evolve through a process of natural
selection, and therefore do not need to be designed or even understood
by a single mind. 22
reach a verdict of market failure and to provide a rationale for government intervention
(see note 13 above). For Hayek, by contrast, the fact that agents are not hyperrational is
an argument not against individual freedom, but against state planning and social control.
20 Earlier Hayek (1933b, p. 27) had used “organism” and “organization,” borrowed from
Mises, to distinguish the two; this is the distinction cited by Coase in his famous 1937
article, “e Nature of the Firm.”
21 On the relationship between the socialist calculation debate and the theory of the firm
see chapter 1 above.
22 For more on spontaneous order see Fehl (1986). Vanberg (1994) argues that Hayek’s

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Hayek and Austrian economics
Clearly, the Austrian revival owes as much to Hayek as to anyone. But
are Hayek’s writings really “Austrian economics”—part of a separate, recognizable
tradition—or should we regard them, instead, as an original,
deeply personal, contribution? 23 Some observers charge that Hayek’s later
work, particularly after he began to turn away from technical economics,
shows more influence of his friend Sir Karl Popper than of Carl Menger or
Mises: one critic speaks of “Hayek I” and “Hayek II”; another writes on
“Hayek’s Transformation.” 24
It is true that Popper had a significant impact on Hayek’s mature
thought. Of greater interest is the precise nature of Hayek’s relationship
with Mises. Undoubtedly, no economist has had a greater impact
on Hayek’s thinking than Mises—not even Wieser, from whom Hayek
learned his craft but who died in 1927 when Hayek was still a young
man. In addition, Mises clearly considered Hayek the brightest of his
generation. 25 Yet, as Hayek (1978) noted, he was from the beginning
always something less than a pure follower: “Although I do owe [Mises]
a decisive stimulus at a crucial point of my intellectual development, and
continuous inspiration through a decade, I have perhaps most profited
from his teaching because I was not initially his student at the university,
an innocent young man who took his word for gospel, but came to him
as a trained economist, versed in a parallel branch of Austrian economics
notion of spontaneous order via group selection is incompatible with methodological
individualism.
23 Wieser’s have generally been considered a personal contribution, by Hayek himself
and others. For a contrary view, see Ekelund (1986).
24 For Hayeks I and II see Hutchison (1981), pp. 210–19; for the “transformation” see
Caldwell (1988). e secondary literature contains some debate about whether Hayek’s
1937 article “Economics and Knowledge” represents a decisive break with Mises in favor of
a Popperian “falsificationist” approach, one holding that empirical evidence can be used to
falsify a theory (though not to “verify” it by induction). For the case that 1937 is a crucial
turning point see Hutchison (1981, p. 215) and Caldwell (1988, p. 528); for the reverse
see Gray (1984, pp. 16–21) and Garrison and Kirzner (1987, p. 610). Hayek (1992,
pp. 55–56; 1994, pp. 72–74) himself supported the former interpretation, maintaining
that it was indeed Mises he had hoped to persuade in the 1937 article. If true, Hayek’s
attempt was remarkably subtle, for Mises apparently welcomed Hayek’s argument, unaware
that it was directed at him.
25 Margit von Mises (1984, p. 133) recalls of her husband’s seminar in New York that he
“met every new student hopeful that one of them might develop into a second Hayek.”

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[the Wieser branch] from which he gradually, but never completely, won
me over.”
Much has been written on Hayek’s and Mises’s views on the socialist
calculation debate. e issue is whether a socialist economy is “impossible,”
as Mises charged in 1920, or simply less efficient or more difficult to
implement. Hayek (1992, p. 127) maintained later that Mises’s “central
thesis was not, as it is sometimes misleadingly put, that socialism is impossible,
but that it cannot achieve an efficient utilization of resources.” at
interpretation is itself subject to dispute. Hayek is arguing here against the
standard view on economic calculation, found for instance in Schumpeter
(1942, pp. 172–186) or Bergson (1948). is view holds that Mises’s original
statement of the impossibility of economic calculation under socialism
was refuted by Oskar Lange, Fred Taylor, and Abba Lerner, and that later
modifications by Hayek and Robbins amounted to an admission that a
socialist economy is possible in theory but difficult in practice because
knowledge is decentralized and incentives are weak. Hayek’s response in
the cited text, that Mises’s actual position has been exaggerated, receives
support from the primary revisionist historian of the calculation debate,
Don Lavoie, who states that the “central arguments advanced by Hayek
and Robbins did not constitute a ‘retreat’ from Mises, but rather a clarification
directing the challenge to the later versions of central planning. ...
Although comments by both Hayek and Robbins about computational
difficulties of the [later approaches] were responsible for misleading interpretations
of their arguments, in fact their main contributions were fully
consistent with Mises’s challenge” (Lavoie, 1985, p. 20). Kirzner (1988a)
similarly contends that Mises’s and Hayek’s positions should be viewed
together as an early attempt to elaborate the Austrian “entrepreneurialdiscovery”
view of the market process. Salerno (1990a) argues, by contrast,
in favor of the traditional view—that Mises’s original calculation problem
is different from the discovery-process problem emphasized by Lavoie and
Kirzner. 26
Furthermore, Hayek’s later emphasis on group selection and spontaneous
order is not shared by Mises, although there are elements of this
line of thought in Menger. A clue to this difference is in Hayek’s (1978)
26 Hayek’s writings on socialist economic calculation are collected in Hayek (1997). See
Caldwell (1997) for an overview.

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statement that “Mises himself was still much more a child of the rationalist
tradition of the Enlightenment and of continental, rather than of English,
liberalism ... than I am myself.” is is a reference to the “two types of
liberalism” to which Hayek frequently refers: the continental rationalist or
utilitarian tradition, which emphasizes reason and man’s ability to shape
his surroundings, and the English common-law tradition, which stresses
the limits to reason and the “spontaneous” forces of evolution. 27
Recently, the relationship between Mises and Hayek has become a fullfledged
“de-homogenization” debate. Salerno (1990a,b, 1993, 1994a) and
Rothbard (1991, 1995) see Hayek’s emphasis on knowledge and discovery
as substantially different from Mises’s emphasis on purposeful human
action. Salerno (1993), for example, argues that there are two strands
of modern Austrian economics, both descended from Menger. One,
the Wieser–Hayek strand, focuses on dispersed knowledge and the price
system as a device for communicating knowledge. Another, the Böhm-
Bawerk–Mises strand, focuses on monetary calculation (or “appraisal,”
meaning anticipation of future prices) based on existing money prices.
Kirzner (1994, 1995, 1996, 1997) and Yeager (1994, 1995) argue, by
contrast, that the differences between Hayek and Mises are more matters
of emphasis and language than substance. 28
27 For more on the complex and subtle Mises–Hayek relationship see Klein (1992,
pp. 7–13) and the references cited therein.
28 Kirzner (1995, p. 1244), for example, writes that Mises’s and Hayek’s critiques of
socialism “are simply different ways of expounding the same basic, Austrian, insight.... To
fail to see the common economic understanding shared by Mises and Hayek, is to have been
needlessly misled by superficial differences in exposition and emphasis. To compound this
failure by perceiving a clash, among modern Austrians, of ‘Hayekians’ versus ‘Misesians,’ is
to convert an interpretive failure into a dogmengeschichtliche nightmare.” For more on the
de-homogenization debate see Herbener (1991, 1996), Salerno (1994a, 1996b), Hoppe
(1996), Boettke (1998), and Yeager (1995). Rothbard (1994, p. 559) identifies three “distinctive
and often clashing paradigms within Austrian economics: Misesian praxeology; the
Hayek–Kirzner emphasis on the market as transmission of knowledge and coordination of
plans—rather than the Misesian emphasis on continuing coordination of prices; and the
ultra-subjectivism of [Ludwig] Lachmann.”
Interestingly, Hayek himself sought to de-homogenize his work from that of free-market
thinkers with whom he disagreed methodologically. In an interview in the 1980s he
described Milton Friedman as a “logical positivist,” who “believe[s] economic phenomena
can be explained as macrophenomena, that you can ascertain cause and effects from
aggregates and averages [Friedman] is on most things, general market problems, sound.
I want him on my side. You know, one of the things I often have publicly said is that one

187
Regardless, there is widespread agreement that Hayek ranks among the
greatest members of the Austrian school, and among the leading economists
of the twentieth century. His work continues to be influential in
business-cycle theory, comparative economic systems, political and social
philosophy, legal theory, and even cognitive psychology. Hayek’s writings
are not always easy to follow—he describes himself as “puzzler” or “muddler”
rather than a “master of his subject”—and this may have contributed
to the variety of interpretations his work has aroused. 29 Partly for this
reason, Hayek remains one of the most intriguing intellectual figures of
our time.
G Williamson and the Austrians †
Oliver Williamson’s 2009 Nobel Prize, shared with Elinor Ostrom, is great
news for Austrians. Williamson’s pathbreaking analysis of how alternative
organizational forms—markets, hierarchies, and hybrids, as he calls
them—emerge, perform, and adapt, has defined the modern field of organizational
economics. Williamson is no Austrian, but he is sympathetic to
Austrian themes (particularly the Hayekian understanding of tacit knowledge
and market competition), his concept of “asset specificity” enhances
and extends the Austrian theory of capital, and his theory of firm boundaries
has almost single-handedly displaced the benchmark model of perfect
competition from important parts of industrial organization and antitrust
economics. He is also a pragmatic, careful, and practical economist who
is concerned, first and foremost, with real-world economic phenomena,
of the things I most regret is not having returned to a criticism of Keynes’s treatise, but it
is as much true of not having criticized Milton’s [Essays in] Positive Economics, which in a
way is quite as dangerous a book.” Quoted in Hayek (1994), pp. 144–45.
29 On puzzlers and masters of their subjects see Hayek (1975). Along with himself,
Hayek named Wieser and Frank Knight as representative puzzlers, and Böhm-Bawerk,
Joseph Schumpeter, and Jacob Viner as representative masters of their subjects. As Hayek
(1975, p. 51) recalled, “I owed whatever worthwhile new ideas I ever had to not being able
to remember what every competent specialist is supposed to have at his fingertips. Whenever
I saw a new light on something it was as the result of a painful effort to reconstruct an
argument which most competent economists would effortlessly and instantly reproduce.”
† Published originally on Mises.org, October 14, 2009.

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choosing clarity and relevance over formal mathematical elegance. For
these and many other reasons, his work deserves careful study by Austrians.
Opening the black box
In economics textbooks, the “firm” is a production function or production
possibilities set, a “black box” that transforms inputs into outputs.
Given the existing state of technology, the prices of inputs, and a demand
schedule, the firm maximizes money profits subject to the constraint that
its production plans must be technologically feasible. e firm is modeled
as a single actor, facing a series of uncomplicated decisions: what level of
output to produce, how much of each factor to hire, and the like. ese
“decisions,” of course, are not really decisions at all; they are trivial mathematical
calculations, implicit in the underlying data. In short: the firm is
a set of cost curves, and the “theory of the firm” is a calculus problem.
Williamson attacks this conception of the firm, what he calls the “firmas-production-function”
view. Building on Coase’s (1937) transactioncost
or “contractual” approach, Williamson argues that the firm is best
regarded as a “governance structure,” a means of organizing a set of contractual
relations among individual agents. e firm, then, consists of an
entrepreneur-owner, the tangible assets he owns, and a set of employment
relationships—a realistic and thoroughly Austrian view. Williamson emphasizes
“asset specificity”—the degree to which resources are specialized
to particular trading partners—as the key determinant of the firm’s boundaries,
defined as the set of transactions that are internal to the firm (or, put
differently, the set of assets owned by the entrepreneur). More generally, he
holds that entrepreneurs will tend to choose the form of organization—a
loose network of small firms, trading in the open market; a franchise network,
alliance, or joint-venture; or a large, vertically integrated firm—that
best fits the circumstances.
Some Austrians have argued, following Alchian and Demsetz (1972),
that Coase and Williamson wrongly claim that firms are not part of the
market, that entrepreneurs substitute coercion for voluntary consent, and
that corporate hierarchies are somehow inconsistent with the free market
(e.g., Ellig and Gable, 1993; Minkler, 1993a; Langlois, 1994a; Mathews,
1998). I think this is a misreading of Coase and of Williamson. It is true
that Coase speaks of firms “superseding” the market and entrepreneurs
“suppressing” the price mechanism, while Williamson says firms emerge

189
to overcome “market failure.” But they do not mean that the firm is outside
the market in some general sense, that the market system as a whole
is inefficient relative to government planning, or anything of the sort.
Moreover, Williamson does not use the term “market failure” in the usual
left-interventionist sense, but means simply that real-world markets are not
“perfect” as in the perfectly competitive general-equilibrium model, which
explains why firms exist. Indeed, Williamson’s work on vertical integration
can be read as a celebration of the market. Not only are firms part of
the market, broadly conceived, but the variety of organizational forms we
observe in markets—including large, vertically integrated enterprises—is
a testament to the creativity of entrepreneurs in figuring out the best way
to organize production.
What about Williamson’s claim that markets, hierarchies, and hybrids
are alternative forms of governance? Does he mean that firms and hybrid
organizations are not part of the market? No. Coase and Williamson are
talking about a completely different issue, namely the distinction between
types of contracts or business relationships within the larger market context.
e issue is simply whether the employment relationship is different
from, say, a spot-market trade or a procurement arrangement with an independent
supplier. Alchian and Demsetz (1972) famously argued that there
is no essential difference between the two—both are voluntary contractual
relationships, there is no “coercion” involved, no power, etc. Coase
(1937), Williamson, Herbert Simon (1951), Grossman and Hart (1986),
my own work, and most of the modern literature on the firm argues that
there are important, qualitative differences. Coase and Simon emphasize
“fiat,” by which they mean simply that employment contracts are, within
limits, open-ended. e employer does not negotiate with the employee
about performing task A, B, or C on a given day; he simply instructs him to
do it. Of course, the employment contract itself is negotiated on the labor
market, just as any contract is negotiated. But, once signed, it is qualitatively
different from a contract that says “independent contractor X will
perform task A on day 1.” An employment relationship is characterized by
what Simon (1951) called the “zone of authority.” Williamson emphasizes
the legal distinction, namely that disputes between employers and employees
are settled differently from disputes between firms, between firms and
customers, between firms and independent suppliers or distributors, etc.
Grossman and Hart, and my own work with Nicolai Foss, emphasize the
distinction between asset owners and non-owners. If I hire you to work

190
with my machine, I hold residual control and income rights to the use of
the machine that you do not have, and thus your ability to use the machine
as you see fit is limited. If you own your own machine, and I hire you to
produce services with that machine, then you (in this case, an independent
contractor) hold these residual income and control rights, and this affects
many aspects of our relationship.
While Coase, Simon, Hart, and other organizational economists do
not draw explicitly on the Austrians, this distinction can also be interpreted
in terms of Menger’s distinction between orders and organizations,
or Hayek’s cosmos and taxis. Coase and Williamson are simply saying that
the firm is a taxis, the market a cosmos. is does not deny that there
are “unplanned” or “spontaneous” aspects of the internal organization of
firms, or that there is purpose, reason, the use of monetary calculation,
etc., in the market.
Asset specificity and Austrian capital theory
As we have seen in prior chapters, the black-box approach to the firm that
dominated neoclassical economics omits the critical organizational details
of production. Production is treated as a one-stage process, in which factors
are instantly converted into final goods, rather than a complex, multistage
process unfolding through time and employing rounds of intermediate
goods. Capital is treated as a homogeneous factor of production.
Williamson, by contrast, emphasizes that resources are heterogeneous, often
specialized, and frequently costly to redeploy. What he calls asset
specificity refers to “durable investments that are undertaken in support
of particular transactions, the opportunity cost of which investments are
much lower in best alternative uses or by alternative users should the original
transaction be prematurely terminated” (Williamson, 1985, p. 55).
is could describe a variety of relationship-specific investments, including
both specialized physical and human capital, along with intangibles such
as R&D and firm-specific knowledge or capabilities. Like Klein, et al.
(1978), Williamson emphasizes the “holdup” problem that can follow such
investments, and the role of contractual safeguards in securing the returns
(what Klein, et al. call “quasi-rents”) to those assets.
Austrian capital theory focuses on a different type of specificity, namely
the extent to which resources are specialized to particular places in the time-

191
structure of production. Menger famously characterized goods in terms of
“orders”: goods of lowest order are those consumed directly. Tools and
machines used to produce those consumption goods are of a higher order,
and the capital goods used to produce the tools and machines are of an
even higher order. Building on his theory that the value of all goods is
determined by their ability to satisfy consumer wants (i.e. their marginal
utility), Menger showed that the value of the higher-order goods is given or
‘imputed’ by the value of the lower-order goods they produce. Moreover,
because certain capital goods are themselves produced by other, higherorder
capital goods, it follows that capital goods are not identical, at least
by the time they are employed in the production process. e claim is
not that there is no substitution among capital goods, but that the degree
of substitution is limited; as Lachmann (1956) put it, capital goods are
characterized by “multiple specificity.” Some substitution is possible, but
only at a cost.
Mises and Hayek used this concept of specificity to develop their theory
of the business cycle. Williamson’s asset specificity focuses on specialization
not to a particular production process, but to a particular set of
trading partners. His aim is to explain the business relationship between
these partners (arms-length transaction, formal contract, vertical integration,
etc.). e Austrians, in other words, focus on assets that are specific
to particular uses, while Williamson focuses on assets that are specific to
particular users. But there are obvious parallels, and opportunities for gains
from trade. Austrian business-cycle theory can be enhanced by considering
how vertical integration and long-term supply relations can mitigate, or
exacerbate, the effects of credit expansion on the economy’s structure of
production. Likewise, transaction cost economics can benefit from considering
not only the time-structure of production, but also Kirzner’s (1966)
refinement that defines capital assets in terms of subjective, individual
production plans, plans that are formulated and continually revised by
profit-seeking entrepreneurs (and Edith Penrose’s, 1959, concept of the
firm’s “subjective opportunity set”).
Vertical integration, strategizing, and economizing
e general thrust of Williamson’s teaching on vertical integration is not
that markets somehow “fail,” but that they succeed, in rich, complex,

192
and often unpredictable ways. A basic conclusion of transaction cost economics
is that vertical mergers, even when there are no obvious technological
synergies, may enhance efficiency by reducing governance costs. Hence
Williamson (1985, p. 19) takes issue with what he calls the “inhospitality
tradition” in antitrust—namely, that firms engaged in non standard
business practices like vertical integration, customer and territorial restrictions,
tie ins, franchising, and so on, must be seeking monopoly gains.
Indeed, antitrust authorities have become more lenient in evaluating such
practices, evaluating them on a case-by-case basis rather than imposing
per se restrictions on particular forms of conduct. While this change may
reflect sensitivity to Chicago School claims that vertical integration and
restraints need not reduce competition, rather than to claims that such arrangements
provide contractual safeguards (Joskow, 1991, pp. 79–80), the
Chicago position on vertical restraints relies largely (though not explicitly)
on transaction-cost reasoning (Meese, 1997). In this sense, Williamson’s
work can be construed as a frontal attack on the perfectly competitive
model, particularly when used as a benchmark case for antitrust and regulatory
policy.
Likewise, Williamson argues that for managers, “economizing” is the
best form of “strategizing.” e literature on business strategy, following
Porter (1980), has tended to emphasize “market-power” as the source of
firm-level competitive advantage. Building directly on the old structure–
conduct–performance model of industrial organization, Porter and his followers
argued that firms should seek to limit rivalry by enacting entry
barriers, forming coalitions, limiting the bargaining power of buyers and
suppliers, etc. Williamson challenges this strategic positioning approach
in an influential 1991 article, “Strategizing, Economizing, and Economic
Organization,” Williamson (1991d) where he claims that managers should
focus on increasing economic efficiency, by choosing appropriate governance
structures, rather than increasing their market power. Here again,
moves by firms to integrate, cooperate with upstream and downstream
partners, form alliances, and such are not only profitable for the firms, but
for consumers as well. Deviations from perfect competition are, in this
sense, part of the market process of allocating resources to their highestvalued
uses, all to the benefit (as Mises emphasized) of the consumer.

193
Coda
On a personal level, Williamson is friendly and sympathetic to Austrians
and to Austrian concerns. He encourages students to read the Austrians
(particularly Hayek, whom he cites often). Williamson chaired my PhD
dissertation committee, and one of my first published papers, “Economic
Calculation and the Limits of Organization,” was originally presented in
Williamson’s Institutional Analysis Workshop at Berkeley. Williamson did
not buy my argument about the distinction between calculation and incentive
problems—he maintained (and continues to maintain) that agency
costs, not Mises’s calculation argument, explain the failure of central planning—but
his reactions helped me shape my argument and refined my
understanding of the core Misesian and Hayekian literatures. (Also, the
great Sovietologist Alec Nove, visiting Berkeley that semester, happened
to be in the audience that day, and gave me a number of references and
counter-arguments.) Williamson, knowing my interest in the Austrians,
once suggested that I write a dissertation on the Ordo School, the influence
of Hayek on Eucken and Röpke, and the role of ideas in shaping economic
policy. He cautioned me that writing on such a topic would not be an
advantage on the job market, but urged me to follow my passions, not to
follow the crowd. I ended up writing on more prosaic topics but never
forgot that advice, and have passed it along to my own students.

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Index
A
agency theory, about, 35, 45
alertness, in entrepreneurship, 96, 102
American Economic Association (AEA),
167
ARPANET, 153
asset specificity, see also heterogeneous
capital; heterogeneous resources or
assets
capital heterogeneity, 72
Williamson on, 5, 190
attributes
entrepreneurship, 116
heterogeneous capital, 75–80, 111
Austrian economics, see also price theory
capital heterogeneity, 75–80
collapse of the Austrian school in
Austria, 178
corporate governance, 28–35
divestitures, 52
economic calculations of entrepreneurs,
32–35
entrepreneurship, 29–31, 68, 94, 111
financiers as entrepreneurs, 45–48
firms, 6, 18–21, 38
Hayek and, 182–187
internal capital markets, 40–48
Menger’s contribution to, 174
Rothbard and economic calculation
under socialism, 16
and Williamson, 187–193
autonomy, compared to freedom and
liberty in the digital revolution,
159
B
Benkler, Yochai, e Wealth of Networks,
157–162
Berle–Means corporations, 43
Bhidé, Amar, on internal capital markets,
41
bibliography, 195–234
black box model
about, 3, 24
opportunities as, 106
shmoo capital, 71
Williamson on, 188–190
boundaries, firms, 84
broken window fallacy, Internet
technology, 156
bureaucracy, 44
business cycle
Hayek’s contribution to theory of, 176,
180–182
and management theory, 169–171
235

236
C
calculation, versus incentives in
determining firm size, 9–13
capital, see also asset specificity;
heterogeneous capital
Austrian economics, 75
theory of the firm, 71–75
Williamson on theory of, 190
capital markets
corporate governance, 35–37
internal capital markets, 40–48
Mises on, 46
capitalist-entrepreneurs, Mises on, 30
capitalists
corporate governance, 25
relationship to managers, 35
case probability, 118, 121
centrally planned economies, see socialist
theories
class probability, 118, 121
Coase, Ronald
compatibility with Austrian economics,
18
Rothbard’s Coasian framework on firm
size, 17
on transaction costs, 4
Coasian framework
about, 27
Rothbard consistency with, 34
collective action, theory of, 115
collectives, holding property rights, 159
competition, Hayek’s contribution to
concept of, 182
conglomerates, unrelated diversification,
51
contracts, entrepreneurial function, 90
contractual approach, corporate
governance, 27
contractual framework, 27
cooperatives, entrepreneurial teams, 114
corporate control, see market for corporate
control
corporate governance, 23–48
Austrian economics, 28–35, 37–48
capital markets, 35–37
contractual approach, 27
entrepreneur-promoter and capitalist
approaches, 25–26
traditional approach, 24
Williamson on, 189
corporations, see corporate governance;
firms; multidivisional (M-form)
corporations
costs, see also transaction costs
agency costs, 36
transaction costs, 4
creation approach, entrepreneurship, 104
D
decentralization, about, 89
digital revolution, Benkler on, 157
discovery approach, entrepreneurship, 104
diversification, and internal capital
markets, 42
divestitures
predictable mistakes hypothesis, 50–52,
60–65
reasons for, 57–59
dummy variables, in research on mergers
and divestitures, 62
E
economic value added (EVA), 39
economizing, Williamson on, 191
efficiency, predictable mistakes hypothesis,
57–60
empire building hypothesis, divestitures,
60, 64
entrepreneur-promoter, corporate
governance, 25
entrepreneurial action
applications of, 113–115
and heterogeneous capital and
economic organization, 109–113
entrepreneurial market process, about, 58
entrepreneurial teams, 114
entrepreneurs, as financiers, 45–48

237
entrepreneurship, see also
capitalist-entrepreneurs;
predictable mistakes hypothesis
Austrian economics, 29–31, 68
heterogeneous capital, 79
Knightian concept of, 19
as an occupational choice, 89
occupational, structural, and functional,
95–99
as opportunity identification, 99–109
productive and destructive, 85
profit and loss, 54–57
risk and uncertainty, 122
sources for theory of, 67
equilibrium
applied to the digital revolution, 162
price theory, 129, 135–150
EVA (economic value added), 39
exchange, relative costs of external and
internal, 4
expectations, convergence to equilibrium
in price theory, 139–150
experimental activity, heterogeneous
capital, 79, 81
external exchange, relative cost, 4
F
final state of rest (FSR), 135–139
financial-market entrepreneur, see
capitalist-entrepreneurs
financial markets, see capital markets
financiers, as entrepreneurs, 45–48
firms, 1–21, see also black box model;
corporate governance;
multidivisional (M-form)
corporations
Austrian economics, 18–21
boundaries of, 84
as controlled experiments, 82
corporate restructurings, value of, 50
diversification and internal capital
markets, 42
divestitures, predictable mistakes
hypothesis, 50–52, 57–59, 60–65
emergence of, 80–83
as investments, 38
output levels, 39
size of, 5–18, 42
theory of, 3, 112
tradeoffs in internal organization, 86
transaction costs, 4
Williamson on, 188–190
fixed costs, allocating, 17
free rider problem, tender offers, 47
freedom, compared to autonomy in the
digital revolution, 159
function activity, entrepreneurship as, 96
G
general equilibrium theory,
entrepreneurship, 93
GI Bill, 165
governance, see corporate governance
government, see also regulation
aid to education sector, 164, 165
intervention in marketplace: effect on
entrepreneurial error, 53
role in creating bureaucracy, 44
role in development of the Internet,
153–157
group selection, 185
H
Hayek, F. A.
the innovator, 131, 175–187
on knowledge problem, 32, 182
on leftward and rightward leanings in
academia and the private sector,
163
on malinvestment, 171
on market socialism, 8
relationship between Austrian and
neoclassical economics, 146–150
heterogeneous capital, 67–91
attributes, 75–80
opportunity discovery, 109–113
organizing and using, 80–87
theory of the firm, 71–75
heterogeneous resources or assets, 170, 190
homogeneity
in economic models, 170
versus heterogeneity, 186

238
I
incentives, versus calculation in
determining firm size, 9–13
information commons, privatizing, 159
intellectuals, support for socialism,
162–169
internal capital markets, Austrian
economics, 40–48
internal exchange, relative cost, 4
Internet, roles of government and market
place, 153–157
investments, firms as, 38
J
judgment
in entrepreneurship, 69, 97, 109, 123
incomplete markets for, 80
K
Kirzner’s framework
about, 29
capital heterogeneity, 76, 80
on convergence toward equilibrium,
139
entrepreneurship, 96, 105
Knight, Frank H.
as an Austrian framework for firm size,
18
on entrepreneurship, 98, 103
on judgment, 70
on probability, 118–121
knowledge-based approach to capital
heterogeneity, 73
knowledge problem
convergence to equilibrium in price
theory, 139–150
Hayek’s contribution to concept of, 32,
182
Kreps, David, on the theory of the firm, 4
L
Lachmann, Ludwig M.
contributions to economics, 131
on convergence toward equilibrium,
139
liberty, and social production, 158
M
M-form (multidivisional) corporations,
internal capital markets, 40
macroeconomics, homogeneity versus
heterogeneity, 170
malinvestment, Hayek on, 171
management theory
and business cycle, 169–171
Mises distinction with
entrepreneurship, 30
Mises on managerial autonomy, 45
role of managers versus capitalists, 35
Manne, Henry, on market for corporate
control, 36
market, role in development of the
Internet, 153–157
market for corporate control
about, 36
regulation of, 52
market socialism
about, 7
Mises on, 11, 23
mathematical solution, see market
socialism
Menger, Carl
on capital heterogeneity, 76
contributions to economics, 133–134,
171–174
price theory, 145
mergers, predictable mistakes hypothesis,
57–60
metaphors, entrepreneurship, 105
Mises, Ludwig von
on calculation debate, 6
on divestitures, 53
on entrepreneurship, 30, 54, 99
on financial markets, 46
on judgment, 123
on managerial autonomy, 45
on market for corporate control, 37
on market socialism, 23
on probability, 118–121
on the purchasing power of money, 143
relationship between Austrian and
neoclassical economics, 146–150

239
relationship to Hayek’s thought, 184
on socialism, 10–13, 176
on uncertainty, 122
mistakes, see predictable mistakes
hypothesis
money, purchasing power of, 143
multidivisional (M-form) corporations,
internal capital markets, 40
N
networks, and social production and
private property, 157–162
O
objective opportunities, versus subjective
opportunities, 101–106
occupational choice, entrepreneurship as,
89, 95
opportunity discovery, 93–116
entrepreneurial action, applications of,
94, 113–115
entrepreneurial action, heterogeneous
capital, and economic
organization, 109–113
occupational, structural, and functional
perspectives on entrepreneurship,
95–99
opportunity identification,
entrepreneurship as, 99–109
opportunity identification,
entrepreneurship as, 99–109
organization, see also black box model;
corporate governance; firms;
multidivisional (M-form)
corporations
and entrepreneurial action and
heterogeneous capital, 109–113
entrepreneurial action, 113
heterogeneous capital, 80–87
risk and uncertainty, 117–124
organizational grind, 109
output levels of firms, in relation to outside
investment opportunities, 39
overhead, allocating, 17
ownership, see property rights
P
packets (Internet), pricing, 155
plain state of rest (PSR), 135–139
predictable mistakes hypothesis, 49–66
divestitures, 60–65
mergers, sell-offs, and efficiency, 57–60
profit and loss in entrepreneurship,
54–57
price-earnings (P/E) ratios, mergers and
divestitures, 61
price theory, see also transfer prices,
125–151
before 1974, 129–134
equilibrium, 135–150
future directions, 150
Hayek’s contribution to, 181
Menger’s contributions to, 171
Mengerian, 145
socialism and, 10
pricing
Internet services, 156
packets on the Internet, 155
Principles, 173
privatizing, information commons, 159
probability, see also uncertainty
Mises and Knight on, 118–121
profit and loss
defined, 39
entrepreneurship, 54–57
property rights
held by collectives, 159
heterogeneous capital, 73, 78
and networks and social production,
157–162
PSR (plain state of rest), 135–139
purchasing power of money, 143
R
radical uncertainty, 145
references, 195–234
regulation, market for corporate control,
52
rents, safeguarding, 28
resource-based approaches to capital
heterogeneity, 73

240
return on investment (ROI), across
multiple subunits, 39
risk, and uncertainty and economic
organization, 117–124
Robbins, Lionel, on market socialism, 8
Rothbard, Murray N.
Coasian framework, 34
on equilibrium constructs, 141
on financial markets, 45
on firm size, 6, 13–18
mundane economics, 130
on socialist economic calculation, 16,
33
on the traditional role of economists,
166
S
Schumpeter, Joseph, on academic
viewpoints, 164
sell-offs, predictable mistakes hypothesis,
57–60
shareholders, control and governance
mechanisms, 36
“shmoo” capital, about, 71
size of firms, 5–18
calculation versus incentives, 9–13
Rothbard on, 13–18
socialist theories, 6–9
social production, and networks and
private property, 157–162
socialist theories
calculation versus incentives, 9
intellectuals support for, 162–169
Mises on, 10–13, 176, 185
pricing problem, 15
Rothbard on socialist calculation
debate, 16, 33
size of firms, 6–9
specificity, see asset specificity;
heterogeneous capital;
heterogeneous resources or assets;
homogeneity
spontaneous order, 185
standard account, in calculation debate, 6
strategizing, Williamson on, 191
subjective opportunities, versus objective
opportunities, 101–106
subjectivist approach
entrepreneurship, 108
subjective probability theory, 120
T
teams, entrepreneurial teams, 114
tender offers, free rider problem, 47
theory of the firm, see also black box model
about, 3
corporate governance, 24
heterogeneous capital, 71–75
transaction costs
firms, 4
shmoo capital, 72
Williamson framework, 19, 192
transfer prices
estimating, 34
Rothbard on, 14
U
uncertainty
entrepreneurship, 99
Kirzner’s framework, 29
Mises on, 30
radical uncertainty, 145
and risk and economic organization,
117–124
units of analysis, opportunity
identification, 107
V
Vaughn, Karen I., on price theory, 128
vertical integration, Williamson on, 191
W
e Wealth of Networks, 157–162
Wicksteedian state of rest (WSR), 135,
137, 138, 139
Williamson, Oliver
and Austrian economists, 187–193
on heterogeneous capital, 83
transaction cost framework, 19
World War II, influence on economics
profession, 167

About the Author
Peter G. Klein is an Associate Professor in the Division of Applied Social Sciences at the
University of Missouri, Adjunct Professor at the Norwegian School of Economics and
Business Administration, and Senior Scholar of the Ludwig von Mises Institute. His
research focuses on the boundaries and internal organization of the firm, with applications
to diversification, innovation, entrepreneurship, and financial institutions. He is author
or editor of four books and author of over fifty scholarly articles. Klein holds a Ph.D. in
economics from the University of California, Berkeley and a B.A. from the University of
North Carolina, Chapel Hill. He blogs at organizationsandmarkets.com.